Background to the Companies Act

To secure the operational efficiency and success of their businesses, SME owners must have a firm grasp of the legal duties imposed on directors. These are called directors duties.

These responsibilities are part and parcel of the powers given to directors in leading the business, making financial decisions and determining corporate policy; breaches of these duties will carry significant legal consequences, which risk a damaged reputation and financial repercussions.

In the realm of corporate governance, English law has assumed a crucial role in setting out the standards for directors and the specific duties imposed on them. The law in this area was previously governed by common law principles of loyalty, care and good faith in the 19th century, and the general duties of directors were outlined for the first time in the Companies Act 1948. 

The Companies Act 2006 significantly reformed and expanded the responsibilities of directors, and consolidated the common law principles into one piece of legislation to serve as a framework for directors’ duties; it remains the most important piece of law concerning the legal duties of directors.

The aim of the Act was to create a more comprehensive and accessible set of principles which would improve the quality of corporate decision-making and make the obligations of directors more transparent, and therefore more enforceable. As such it is imperative that directors of SMEs have a thorough understanding of their legal obligations to ensure compliance with English law, maintain the integrity of their company and protect the interests of various stakeholders.

Three Specific Areas to understand

1. Duty to Act within Powers

The first duty encompasses the obligation of the director to act within their powers, that is to exercise them in line with the company’s constitution and bylaws. This serves to limit the power of the director to make decisions that fall outside their authority and maintain the internal resolution of the company following their objectives and goals. For SMEs, the director must uphold these internal processes early on so that there is a clear framework to which they can refer throughout the growth and expansion of the company.

2. Duties to Promote the Success of the Company and Exercise Reasonable Care, Skill and Diligence

The duty to promote the success of the company requires directors to act in the best interests of different stakeholders, including employees, shareholders, suppliers and customers when determining the best path for sustainable growth.

Directors must consider the long-term vision of the company and not act only for immediate gains, whilst upholding high standards of business practice and ethical conduct. This is particularly important for SMEs. Directors will need to promote the success of the company for the benefit of its members as a whole and solidify their professional relationships to maintain a good reputation going forward.

This duty goes hand in hand with the duty of directors to exercise reasonable care, skill and diligence. This holds both ethical and legal implications. Directors must endeavour to make decisions in good faith, consulting experts if needed, and remain well-informed of the realities of the company and its activities to ensure best practice.

This duty also necessitates that directors actively engage in any board meetings or other governance structures to uphold the company’s values and inform their employees of any legal changes that might affect their work.

3. Maintaining Independence, Integrity and Transparency

Finally, the Companies Act goes into further detail about making independent decisions and maintaining integrity and transparency. For example:

  • the duty to exercise independent judgement
  • the duty to avoid conflicts of interest
  • the duty not to accept benefits from third parties
  • the duty to declare interest in proposed transaction or arrangement.

The duty to exercise independent judgement is a negative one which requires directors not to be unduly influenced by others when making decisions. For SME directors, it is crucial that when consulting experts or industry specialists, they maintain a level of autonomy in deciding whether or not to act on their advice and ensure transparency when dealing with any external stakeholders.

Integrity – conflit of interest

The duty to avoid conflicts of interest reiterates that directors must act in the best interests of the company and its shareholders, and to avoid situations where their personal interests may conflict with those of the company. The practical implications for this duty include identifying and disclosing potential conflicts effectively and maintaining the highest level of transparency when completing transactions of this nature.

Transparency

This obligation goes hand in hand with the duty not to accept benefits from third parties and the duty to declare interest in a proposed transaction or arrangement.

In both situations, the director stands to achieve personal gain at the company’s expense, and so it is their responsibility

  • to refrain from circumstances where their position allows personal benefit which doesn’t fully align with the company’s interests;
  • and to make it very clear that this is not the case.

In these situations, having a robust governance framework will ensure clear structures and policies through which to address potential conflicts of interest and properly disclose benefits.

Directors must regularly reflect on and update procedures to ensure compliance. It might be useful to establish an independent body or consult an advisor to oversee potential conflicts and ensure compliance with these standards.

Principles from Recent Case Law

One recent case which went to the UK Supreme Court in 2022 highlighted the importance of exercising independent judgment and acting in the company’s best interest.

Sequana

The case of Sequana made it clear that directors also have a duty to act in the best interests of creditors if their company has become financially distressed. Once insolvency has become irreversible, the interests of creditors must be held at a higher priority over any other interest.

This illustrates how the duties of directors can change in line with the company’s financial position. This case emphasises that directors must stay as informed as possible about the company’s financial information to fulfil their duties. If thorough processes for updating directors are implemented early on, staff members will be more likely to appreciate the importance of updated information, and this will ease compliance with directors’ duties.

Burnell

The case of Burnell in 2021 also has significant implications as it extended directors duties to avoid conflicts of interest to include a period after the director leaves their role. Continuing the duty was held to ward against misuse of information gained whilst a director is in office; the decision in this case made it clear that the duty of trust which a director holds cannot be immediately terminated by leaving their post, and this also applies to de facto directors.

Despite the strict nature of the duties imposed on directors, it is important to remember that the law only requires directors to do what is reasonable in the circumstances.

Green v Walkling

In Green v Walkling, the court decided that although a director had become aware of possible money laundering in his company, which is a very serious offence, as he had sought legal advice in this matter and acted in accordance with it, this was deemed to be enough to fulfil his duty of reasonable care, skill and diligence.

Humphrey

Lastly, the case of Humphrey has exemplified the importance of consistency when a company has multiple directors. The directors duties are imposed on each person individually; even if one has a potential conflict of interest and another does not, each can be held liable for something they ought reasonably to have known about. Proper communication and rigorous disclosure processes are once again proven to be crucial in this area.

Consequences of Breach of Directors Duties

Breach of any of the duties imposed on directors can have both legal and financial consequences. As mentioned above, directors can be held personally liable for losses incurred by the company or its stakeholders due to their breach of duty; for example, similar to the Sequanacase, if a director allows the company to trade while insolvent, they might be held personally responsible for the debts incurred at that time.

Regulatory bodies could also impose fines on directors who breach their duties, in addition to costs imposed through legal proceedings, as shareholders and creditors may also bring legal action against a director in breach of their obligations. This may also lead to disqualification from the role of director, so there is a significant risk of loss of reputation, both personal and professional. In the most serious cases, extreme breaches of duty may lead to criminal charges against a director (R v Boyle).

Final words

The role of a director embodies a complex web of responsibilities, obligations and ethical considerations. As custodians of the company’s interests, directors have a duty of trust to act with care, loyalty and prudence in their actions, and their legal obligations serve to protect these interests and promote transparency and informed decision-making.

To navigate this intricate landscape it is of paramount importance that principled corporate governance is made a priority and both directors and employees have a thorough understanding of the variety of required directors duties. In the context of SMEs, the impact of directors’ decisions are even more evident, but by recognising these duties and ensuring structures of corporate governance are in place, directors pave the way for sustainable growth and enhanced stakeholder trust.