This guide is based on UK law as at 1st February 2010, unless otherwise stated.
If a director breaches any of his or her duties (see The code of directors' duties, an OUT-LAW guide), what are the consequences?
Claims by the company
The company itself can bring a claim against the erring director if it can show that it has suffered some loss. If the director has made some personal profit, they can be required to surrender the gain to the company.
A contract or other arrangement entered into by the director in breach of a duty will be void, though it may be open to the company to ratify the agreement if it wishes to do so.
The company may also seek:
- an injunction to stop the director from carrying out or continuing with the breach;
- damages by way of compensation where the director has been negligent;
- restoration of the company’s property;
- the rescinding of a contract in which the director had an undisclosed interest.
Claims by a company are often retrospective, brought by members of the existing board against their predecessors. (It is, after all, unlikely that a board will choose to sue itself; turkeys don’t vote for Christmas.) In 2002, for example, the newly installed directors of Equitable Life voted to pursue the company’s former directors for the losses it had suffered as a result of problems with its guaranteed income policies. It was only after several years of crippling litigation, which pushed a number of the defendants towards bankruptcy, that the company agreed to withdraw its claims.
Errant directors can also face claims against them when a company is sold. The new owners may appoint new directors and, if things go wrong, they may cast around for past breaches of duty and the opportunity to hold the old directors to account.
Claims by a liquidator or administrator
Once a company becomes insolvent, a liquidator or administrator will be under a duty to consider a claim against a director where a breach of duty is discovered. A claim will be treated as an asset of the company: it will be pursued and realised for the benefit of creditors.
A director owes their duties direct to the company, and only the company can complain of any breach. Shareholders have no right to claim against a director for any loss they believe they may have suffered as a result of breach of duty. However much their shares have dropped in price, they cannot recover that loss of value from the directors they hold responsible.
But because few companies will bring a claim against one of their own directors, the law has, over the years, developed a mechanism that allows shareholders to force the company to seek redress. With the permission of the court, shareholders can bring a claim against a director in the name of the company. The claim is initiated and run by shareholders, but it is brought in the company’s name and to recover the company’s loss.
The distinction is important: the shareholder is not claiming in their own name for their own loss; rather, they are claiming in the company’s name for the company’s loss. It follows that any sum recovered goes to the company (and it will be the board’s decision whether to pass the benefit on to shareholders by way of dividend).
These principles were established over 150 years or so by judges deciding the cases before them. The Companies Act 2006 tidied up the rules under the heading ‘derivative claims’, the technical term for this type of legal proceeding (see Derivative claims: more power to the shareholder, below).
These rules apply not just to a director’s breach of the duties described in this book but also to a director’s negligence and any other failure that may have been committed. There is no need to show that the director has benefited personally, and both present and past directors may be pursued. Shareholders can use the procedure to pre-empt an anticipated act or omission, as well as to claim for shortcomings in the past.
So what exactly is the procedure? A shareholder dissatisfied with a board’s lack of action against an errant director must issue a claim in the name of the company and request the court’s permission to take it forward. A successful shareholder will be allowed to pursue the claim (with the company footing the bill), but the court has a wide discretion to adjourn the case to gather evidence from the company itself. An unsuccessful shareholder risks paying the other parties’ costs and an order restraining further action.
Crucially, permission to pursue a claim will only be granted if the court decides there is a prima facie case to answer. How will a court decide whether that prima facie case exists? The following are the key criteria:
- Is it in the best interests of the company to pursue the matter through the courts; or does the shareholder have their own agenda/ulterior motives?
- Would a director acting in accordance with the duty to promote the success of the company (see: The Code of Directors' Duties, an OUT-LAW guide) continue the claim?
If the decision is that such a hypothetical director would drop the claim, the case must be dismissed.
Other factors to be taken into account include: whether the shareholder is acting in good faith in bringing the claim (or just being vexatious); the views of other shareholders who have no personal interest in the claim; and whether the shareholder has other remedies available, such as a claim under a shareholders’ agreement.
If the shareholders authorised the act complained of in advance, or they ratified it after the event, that’s enough to stop the claim in its tracks.
Because the shareholder is claiming for the company’s loss, not its own, it is irrelevant whether it has a million shares or just one, and whether it has owned those shares for decades or just days. Consequently, it’s possible for a lobby group that objects to a company’s environmental policies, say, to buy one share and launch a derivative claim against the directors for breach of duty. The fact that the harm complained of occurred before it became a shareholder is irrelevant. Such campaigners will nonetheless face an uphill task in convincing the court that they are acting in the company’s best interests and not just pursuing their own narrow beliefs.
Derivative claims: more power to the shareholder
Derivative claims by shareholders against directors are not new, but setting the rules out in legislation for the first time (in the Companies Act 2006) raised their profile. This led to fears that:
- activist shareholders (perhaps with experience of the US courts) seeking to persuade a board to sell a business or enter into a merger would use the claims as a tactical device to put pressure on nervous directors;
- directors, facing the threat of personal liability for some imagined wrong, would quickly accept whatever the loudest shareholder called for.
With various safeguards built in to the procedure for making a claim, those fears have not been realised. To summarise:
- the shareholder has to have a prima facie case - frivolous or time-wasting claims will go nowhere;
- the success of the company remains paramount - litigation will only go ahead if it's genuinely in the company's best interests;
- the shareholder must be acting in good faith in the interests of the company as a whole;
- the views of other shareholders will be taken into account, and an ordinary resolution in favour of the directors will trump all opposition;
- a shareholder without a good case will be at risk on costs, its own and the company's.
The courts will not second guess a board decision taken in good faith that appeared reasonable at the time, whatever may have transpired subsequently.
Whatever the circumstances, regardless of who is in the right and whether or not there has been a breach of duty, shareholders always have the right to remove a director by ordinary resolution. That right is enshrined in statute and cannot be taken away by a company’s articles.
The director’s employment rights will, however, be unaffected by the shareholder vote: the company will have to pay out for any notice period agreed under the director’s service contract.
Even where a director’s breach of duty is clear, the shareholders can ratify it after the event by passing an ordinary resolution (that is, a simple majority vote – see Company meetings, an OUT-LAW guide). If the errant director is also a shareholder, they cannot vote in their own favour; neither can their family or others connected with them.
A director in breach of a duty may also be relieved of any liability if they can convince the court that they acted honestly and reasonably in all the circumstances. This might happen where a director acted in good faith on the advice of a lawyer or other professional, but where the advice proved to be wrong.
Directors need not wait for proceedings against them before seeking the court’s protection. They can bring their own action for a court order to exempt them from liability.