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Company Lawyer
1998

Disqualification of directors: a faulty regime?

Kingsley T.W. Ong Subject: Company law Keywords: Directors; Disqualification orders Legislation: Company Directors Disqualification Act 1986

*Comp. Law. 7 Disqualification regime

The ability to set up and run limited liability companies is a privilege conferred by statute. The UK Companies Act 1985, Table A, article 70 (which is adopted by most companies in the UK) vests absolute power in the board of directors subject to the constitutional documents of the company. Company directors have thus been described as a self-perpetuating oligarchy1 --a company is like a state governed by a few people. Therefore, the opportunities for errors or fraud by directors on members, creditors, employees and the public and society at large are many. The Companies Act 1985 sets out many regulations,2 criminal sanctions3 and remedies. However, these only offer an ex post facto control of directors' accountability, after the harm has been caused and the damage suffered. Innocent third parties (eg creditors and investors) might incur substantial losses occasioned from the abuse of corporate personality and limited liability privileges, without any form of redress. While disqualification of directorship has an incidental punitive and deterrent effect, its primary purpose has been asserted to be protective.4 It removes the offending person from the sphere of corporate direction and management. Hence, the present disqualification regime prevents the possibility of recurrence of the omissions or misconduct that led to the disqualification. Disqualification is presently the only curtailment of the statutory privilege to form limited liability companies.5 It is in this respect that the regime for disqualifying directors acquires considerable importance in a number of jurisdictions. This article will examine the problems of implementing the disqualification regime, with an attempt to identify the underlying cause of these problems. The primary focus for discussion will be the UK context. However, comparative studies with other jurisdictions which have adopted relatively similar regimes for disqualifying directors will be made.

Is the disqualification regime working?

Improving the standards of company stewardship has been identified as the most important objective of the Company Directors Disqualification Act 1986 (hereinafter the CDDA).6 However, according to a recent survey, 58 per cent of company directors in the UK have never heard of the CDDA.7 Deterrence is an important element in achieving proper ex ante public protection.8 This lack of awareness among company directors of disqualification arrangements implies that disqualification has only very limited utility as a deterrence of irresponsible directorial behaviour.9 Implementation is incomplete if people are not educated. In Singapore, compliance is high compared to other countries. 10 First, the media helps in public education.11 Secondly, all company directors in Singapore must know about disqualification laws because they are required to declare so in their Consent to Act form.
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*Comp. Law. 8 Enforcement is another problem. Even the most draconian laws against delinquent directors will be useless if enforcement is defective. Under s 7 of the CDDA, the task of enforcing the UK disqualification regime rests on the Secretary of State for Trade and Industry and his official receivers. In practice, the Insolvency Service Executive Agency is delegated the responsibility for exercising the Secretary of State's powers. The Insolvency Service normally takes up to two years to initiate disqualification proceedings. Following that, court proceedings normally take up to four years. Therefore, it can take up to six years in total from insolvency involving unfit conduct to disqualification. 13 During this time, the directors concerned still continue normal business activities.

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Proceedings must be brought within two years from insolvency in the UK.14 To safeguard the rights of defendants, an application for a disqualification order out of time will be refused.15 Owing to a lack of resources, it was estimated that up to half of those cases meriting disqualification in the public interest never result in proceedings.16 Even where proceedings are brought within the time limit, the courts tend to adopt a cautious approach. They assert that disqualification is meant to be protective rather than to punish directors. The problem is that disqualification does contain some penal element, although it is meant to be protective in nature.17 The powers of the court to make disqualification orders are consolidated in the CDDA. Under the CDDA, the courts may make a disqualification order against a person on the grounds of general misconduct. Disqualification orders may also be made against a person found guilty of fraudulent or wrongful trading under ss 213-214 of the Insolvency Act 1986.18 But the majority of UK disqualification cases involve the question of unfitness under s 6 of the CDDA.19 A director of an insolvent company found unfit to manage a company will be disqualified.20 Section 6 of the CDDA requires a two-year-minimum mandatory disqualification if unfitness is found.21 Therefore, there is no judicial discretion to avoid imposing a period of disqualification if unfitness is found. This is more stringent than its predecessor, s 300 of the Companies Act 1985.22 Though the courts must have particular regard to Schedule 1 of the CDDA,23 the Schedule is not exhaustive.24 Therefore, the courts are generally left with the task of determining unfitness. Mismanagement and failure are not ipso facto grounds for disqualification.25 Directors who exceed their powers are not necessarily unfit as directors. Persistent abuse of directorial power may be subject to action by shareholders,26 but it is not a sufficient ground for disqualification per se. Disqualification requires something extra.27 This has been referred to as breach of commercial morality,28 lack of commercial probity,29 gross negligence or total incompetence,30 cynical exploitation31 of limited liability privilege, personal dishonesty,32 etc. These phrases have been described as vague.33 They generally infer some form of blameworthiness. 34 Despite this, the unfitness concept lacks clarity. Its meaning rests on a question of fact rather than law.35 This is illustrated in Re Cladrose Ltd [1990] 6 BCC 11, where two directors of insolvent companies had failed entirely to produce audited accounts and file annual returns. The first defendant (D1) maintained that he relied on the second defendant (D2), who was a chartered accountant. D2 was found to be unfit and disqualified for two years, whereas D1's failures were held as insufficient to demonstrate unfitness. It was found that there was no element of serious misconduct or deliberately running the companies into the ground. The directors had also suffered genuine misfortunes and lost very substantially. Furthermore, it was accepted that there was no intention to deceive creditors or the public; and that the lodging of accounts would not in the event have protected the creditors.36 In drawing a distinction in assessing the two directors' liability to disqualification in Re Cladrose, the courts have turned to punitive considerations rather than the protective principles.37 Directors will escape disqualification, even if the public is prejudiced, unless they personally show a high degree of culpability. Finch argues for a stricter approach, asserting that this cautious approach is inconsistent with the public-protection principle, and that there should be some minimum professional standards for directors.38 The efforts and trouble of initiating applications for disqualification will be frustrated if the judges are too complacent on directorial delinquency. It is doubtful whether s 6 of the CDDA was an improvement on s 300 of the Companies Act 1985.39 A court may not consider it proper to disqualify in every case where unfitness exists. Under s 300 of the Companies Act 1985, the courts could exercise their discretion not to disqualify notwith *Comp. Law. 9 standing a finding of unfitness. Further, for example, instead of making a blanket disqualification, the courts could exempt certain companies from the ambit of the order.40 Now, under s 6 of the CDDA, if it was felt that disqualification was too harsh, the courts are forced to avoid finding unfitness altogether.41 Whether disqualification is ordered or not is now determined by unfitness. So a director may escape disqualification even if his conduct falls below a standard the court considers unacceptable, should the court conclude that it does not amount to unfitness.42 Disqualification is not meant to be penal, but purely protective. Section 6 of the CDDA does not allow the court flexibility to strike a proper balance. This has forced the courts to decide against a finding of unfitness to avoid severe penal

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consequences, even though it would be in the public interest to do so.43 It has also forced the courts to invoke unnecessarily severe penal-like consequences in line with protecting the public.44 While protecting the public is important, it is also essential that the rights of defendants be safeguarded.45 The underlying difficulty faced by the courts is that the whole rationale for forming a limited liability company is to allow and encourage entrepreneurial risk-taking. Excessively defensive management will defeat this objective. Disqualification is sometimes regarded as a more draconian penalty than a fine or imprisonment.46 Harsh judgments on disqualification will deter entrepreneurs from taking risk. This conflict has left the law rather unclear, especially as regards what amounts to unfitness. Recentreports suggest a sudden increase in the number of court proceedings against unfit company directors.47 The reports also indicate an increase in the number of disqualification orders made by courts. For example, two recent cases show the courts are unwilling to limit the scope and effect of the disqualification regime.48 Disqualification orders may be imposed for up to 15 years in serious cases, such as fraudulent trading. It may be up to five years for less serious cases.49 The recent reports record an increase in the number of cases disqualified between five and 15 years.50 Though this increase could be an indication of the Insolvency Service taking more action, it also indicates that there is an increase in the extent of insolvency and unfit conduct.51 Studies show there has been an exponential increase in the volume of insolvency cases in recent years.52 This means that enforcing the disqualification regime will only get harder. Finally, even after successfully obtaining disqualification orders, there is little to ensure compliance. Presently, there are no arrangements to ensure that disqualified directors resign. Newly registered directors are not the subject of disqualification orders.53 Furthermore, a recent case has been criticised for allowing disqualified persons an unjustified degree of involvement in the affairs of a company.54 The UK public register of disqualified persons is also poorly maintained. It was reported that there was a significant number of disqualified directors not recorded on the register.55 Singapore has tried to overcome this problem by automatic disqualification.56 There is no register of disqualification orders in Singapore, since there are no disqualification orders with automatic disqualification.57 Hicks argues that imposing automatic disqualification without any proper register would result in confusion because neither the public nor disqualified persons can discover if they have been disqualified.58 However, it is little better to have a poorly maintained register than no register at all. Therefore the disqualification regime has not been very successful in protecting the commercial world and the public at large against directors who abuse limited liability status.59

Identifying the problem

The National Audit Office60 and the Public Accounts Committee61 stressed that the problem lies more with the system and its implementation, ie it is more a procedural problem than a substantive one. If that is the underlying fault which is preventing the disqualification regime from offering effective public protection, perhaps it is worthwhile considering automatic or mandatory disqualification (ie without having to obtain a court order).62 It eases the burden on authorities and avoids the delays inevitable in court proceedings. Presently, disqualification is automatic upon bankruptcy. Further, in Australia and Singapore, automatic disqualification is applied following certain convictions.63 In Singapore, disqualification is also automatic on persistent default in filing documents.64 However, automatic disqualification involves a presumption of unfitness. This has been commented to be unfair, contrary to natural justice and risks penalising the innocent.65 *Comp. Law. 10 Further, it may discourage the appointment of non-executive directors and other directors when a company is in financial difficulty. Automatic disqualification would also cause economic disruption and sterilisation of expertise. Theoretically, shareholders can appoint new directors. But where the disqualified directors are the owners of the company, they cannot appoint themselves anymore. Further, they face difficulties finding people who are willing to run their company for them--for no reasonable person would want to get involved in a troubled company. In Singapore, where 99 per cent of companies are private, this problem is substantial. The Registrar of Companies ended up striking off the names of such companies as they became defunct. Where the burden bounces back to the government, one can conclude that the regime does not work. It is therefore believed that automatic disqualification would deter enterprise and entrepreneurs generally.66 Of course, procedural shortcomings may well have a consequential effect on the substantive part, but procedural shortcomings will not affect the soundness of the original rationale behind the regime,

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whatever that may be. The reluctance to implement automatic disqualification, and the confusion about the law on imposing disqualification orders, indicate that the weakness in the disqualification regime lies beyond its implementation and enforcement. Mr Justice Lightman recently stressed that prevention is better than cure.67 Therefore, motivating an ex ante directors' accountability is important in offering effective public protection. We always tend to blame the directors. But if the law is itself unclear, it is very difficult for the directors (or their legal advisors) to know the limits and boundaries that the law will allow. Promoting proper ex ante directors' accountability is necessary to clarify the law in this area. As such, it was recommended that people should qualify rather than just be disqualified as directors.68 However, to start a system for qualifying directors would require initiatives for a training and licensing course. Problems such as cost will arise. More importantly, requiring a qualification to become a director would be restrictive on entrepreneurs. Perhaps it is because of these problems of implementation that Mr Justice Lightman chose to qualify his recommendation to apply it only to public companies.69 Other possible ex ante controls of directors' accountability include introducing a requirement for higher capital to start a company or making it more difficult to form companies (eg higher registration fees, longer procedures etc). But this would again have the unintended effect of deterring entrepreneurs.70 The courts have asserted on many occasions that the purpose of disqualification is public protection. 71 To protect the public, directors must be made to act responsibly. Therefore, ensuring directorial accountability is important. Both ex post facto and ex ante controls are necessary in maintaining proper directors' accountability.72 Here lies a paradox. To protect the public effectively, ex ante accountability is important. Given that company law offers no other existing mechanisms to provide ex ante control of directors, the disqualification regime becomes significant. Disqualification comes closest to providing for ex ante control of directorial accountability. The regime is thus expected to fill this lacuna in company law. For example, in Singapore the introduction of automatic disqualification73 resulted because Singapore considered enforcement orders and criminal sanctions (eg the possibility of increased fines for subsequent offences) as inadequate to deal with the difficulties in enforcing statutory obligations.74 Ironically, there are fears that excessive implementation of ex ante controls would deter entrepreneurs and defeat the purpose of forming limited liability companies. Discouraging the use of companies, without any alternative corporate form, would not make much economic sense.75 Owing to such fears, the disqualification regime has been diluted with many vague qualifications. These vague qualifications result in unclear laws. Owing to similar fears, the regime has not been implemented strictly and carried to its full potential. It thus fails to ensure proper ex ante directors' accountability which is expected of it. Consequently, it fails in its purpose of protecting the public. The question is predicated on an a priori assumption--what is the purpose and rationale of having the disqualification regime in the first place? An assessment of the regime's success or failure can only be made in the light of its original raison d'tre. Is the disqualification regime there to protect the public, or is it to reassure the public? If it is the former, then promoting proper ex ante and ex post facto directors' accountability is important. If it is the latter, then the priority given to encouraging entrepreneurs over public protection is more justified. In that case, maybe the automatic disqualification of bankrupts should be modified, since some bankrupts became bankrupt for reasons not necessarily amounting to prima facie unfitness. For example, it does not seem to make sense to disqualify bankrupts who became bankrupt because they stood as guarantors or sureties for relatives or friends. Attempting to extend the disqualification regime to protect the public, while making many qualifications for fear of restricting entrepreneurs, is unreasonable and unrealistic. It amounts to public reassurance, not public protection. The disqualification regime has been significantly stretched to its limits. Further unorthodox qualifications and extensions would only make the law more vague. This will hinder, rather than improve, any advancement to promote ex ante accountability. In conclusion, the fundamental problem underlying the regime for disqualifying directors is determining the proper raison d'tre for the regime to begin with. Kingsley TW Ong

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Comp. Law. 1998, 19(1), 7-10

1. 2. 3.

A Hicks, Disqualification of Directors--Forty Years On (1988) Journal of Business Law 27 at 28. Eg keeping extensive company registers and records, up dating and auditing accounts etc. A director can be charged with over 200 different offences under the Companies Act 1985: see V Finch, Personal Accountability and Corporate Control: The Role of Directors' and Officers' Liability Insurance (1995) Modem Law Review 880. Re Rolus Properties Ltd [1988] BCC 446 at 449 per Harman J. See also Re Lo-Line Electric Motors Ltd [1988] Ch 477 at 486 per Browne-Wilkinson VC. See also CDDA, s 8(1): disqualification is justified only on the basis that it is in the public interest to do so. But see V Finch, Disqualification of Directors: A Plea for Competence (1990) Modem Law Review 385, who is unconvinced that the courts are really concerned purely with the protective principle in these cases. Mr Justice Lightman, The Challenges Ahead: Address to the Insolvency Lawyers' Association (1996) Journal of Business Law 113 at 125. Public Accounts Committee, Insolvency Service Executive Agency, Company Directors Disqualification, 1993/4 House of Commons 167 at v. National Audit Office, Insolvency Service Executive Agency, Company Directors Disqualification, 1992/3 House of Commons 907 at 2; and Public Accounts Committee (note 6 above ) at v. National Audit Office (note 7 above ) at 3. The National Audit Office (note 7 above ) quoted further statistics implying the limited success of the deterrent effect of the CDDA. Of the 42 per cent who are aware of the CDDA's existence, 53 per cent considered the legislation unsuccessful in deterring unfit conduct; and 43 per cent thought that proceedings were not brought against a sufficient number of unfit directors. Even among insolvency practitioners, 73 per cent thought that the CDDA does not protect the public interest and 61 per cent felt that the CDDA does not deter unfit conduct. Firms Better Behaved Today Than 8 Years Ago, Singapore Straits Times, 1 August 1991. Examples include 11 Firms Which Did Not File Annual Returns Pay Stiffer Fines, Singapore Straits Times, 19 July 1988; and Tough Penalties Await Tardy, Singapore Business Times, 19 July 1988. For an original copy of Singapore's Consent to Act as Director and Statement of Non-Disqualification to Act as Director (Form 45), see Sia Suat Hwa, Business Firms and Companies, 4th edn (Singapore: Times Books International, 1996) at 73. National Audit Office (note 7 above ) at 2. CDDA, s 7. Re Crestjoy Products Ltd, Secretary of State for Trade and Industry v Goddard (1989) unreported, 18 October, Chancery (on Lexis; and cited in J Dine, Punishing Directors (1994) Journal of Business Law 325 at 333). National Audit Office (note 7 above ) at 2. See also Public Accounts Committee (note 6 above ) at v. Dine (note 15 above ) at 333. CDDA, s 10. J James, Paying for the Benefits of Incorporation: Disqualifying Unfit Directors (1996) 19 Student Law Review 11; and Dine (note 15 above ) at 329. The grounds for disqualification in CDDA, ss 2-5, 8 and 10 are specific in nature, whereas CDDA, s 6 is more general. Therefore, most cases will fall under s 6. CDDA, s 6. CDDA, s 6(4). Under Companies Act 1985, s 300, the applicant for a disqualification order against another person must prove unfitness and that the respondent should be disqualified. The government's initial proposal was even more stringent, requiring a presumption of guilt for automatic disqualification of directors of all insolvent companies. This would leave the onus of proof that disqualification should not be ordered on the directors concerned. See Drake, Disqualification of Directors--The Red Card (1989) Journal of Business Law 474 at 477. CDDA, s 9.

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8. 9.

10. 11.

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13. 14. 15.

16. 17. 18. 19.

20. 21. 22.

23.

Page6 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. Re Bath Glass Ltd [1988] BCLC 329 at 332 per Peter Gibson J. Eg Re Churchill Hotel (Plymouth) Ltd [1988] BCLC 341. Companies Act 1985, s 459. Drake (note 22 above ) at 479. Re Dawson Print Group Ltd [1987] BCLC 601 per Hoffman J. Re Lo-Line Electric Motors Ltd [1988] BCLC 698 at 703. Ibid. Re Douglas Construction Services Ltd [1988] 4 BCC 553 at 557. Re DJ Matthews (Joinery Design) Ltd [1988] 4 BCC 513 at 518. Drake (note 22 above ) at 479. See also F Fitzpatrick, Disqualification of a Director on Grounds of Unfitness (1992) New Law Journal 596, who describes unfitness as a concept of indeterminate meaning. Finch (note 4 above ) at 387, citing authorities from Re Lo-Line Electric Motors Ltd [1988] BCLC 698 and Re CU Fittings Ltd [1989] 5 BCC 210. Fitzpatrick (note 33 above ) at 596. Re Cladrose Ltd [1996] 6 BCC 11 at 14 per Harman J. Finch (note 4 above ) at 388. Ibid at 389. Under Companies 1985, s 300, a director had to be associated with two successive insolvencies before being subjected to disqualification. Therefore, the CDDA lowered the threshold for disqualification. Re Majestic Recording Studios Ltd [1988] 4 BCC 519. Drake (note 22 above ) at 479. See also Fitzpatrick (note 33 above ) at 596 and Finch (note 4 above ) at 389 who adhere to similar arguments. Re Austinsuite Furniture Ltd [1992] BCLC 1047; and Re Bath Glass Ltd [1988] BCLC 329. Eg Re Churchili Hotel (Plymouth) Ltd [1988] BCLC 341. Eg Re Stanford Services [1987] BCLC 607. Dine (note 15 above ) at 333. See also Re Crestjoy Productions Ltd [1990] BCC 23 per Harman J. Drake (note 22 above ) at 474. Insolvency Service Gets Tough on Unfit Directors (1995) 16 Company Lawyer 108; and Record Numbers of Directors Are Disqualified (1995) 16 Company Lawyer 283. See also Drake (note 22 above ) at 486 for 1986, 1987 and 1988 disqualification statistics from the Disqualification Unit of the Insolvency Service. R v Goodman [1994] BCLC 349; and Re Seagull Manufacturing Co Ltd (No 2) [1994] BCLC 273. LS Sealy, Cases and Materials in Company Law, 5th edn (London: Butterworths, 1992) at 311. Ibid. Over the last quarter of 1995, disqualification orders reached 111, a 68 per cent increase over the same period in 1994. See More Disqualification Proceedings But Fewer Disqualified (1994) 15 Company Lawyer 281. Between 1987 and 1988, there were 24,000 insolvencies in the UK; between 1992 and 1993, there was a dramatic increase to 81,000 insolvencies: see National Audit Office (note 7 above ) at 2. Public Accounts Committee (note 6 above ) at vii. Re Rishborough Furniture Ltd [1996] BCLC 507. Criticised by James (note 19 above ) at 12. National Audit Office (note 7 above ) at 3; and Public Accounts Committee (note 6 above ) at vi. In Singapore, automatic disqualification occurs under s 148 (bankruptcy), s 149 (double corporate insolvency), s 154

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35. 36. 37. 38. 39.

40. 41.

42. 43. 44. 45. 46. 47.

48. 49. 50.

51. 52.

53. 54. 55. 56.

Page7 (convictions in connection with management), and s 155 (persistent default) of the Singapore Companies Act (Cap 50). 57. A Hicks, Disqualification of Directors for Persistent Default in Filing Documents: Section 155, Companies Act (1985) 27 Malayan Law Review 329 at 352. Ibid. National Audit Office (note 7 above ) at 3. Note 7 above. Note 6 above. See Cork, Report of the Review Committee: Insolvency Law and Practice (London: HMSO, Cmnd 8558, 1982) at para 1826, which recognised the burden on the authorities to apply to the court for disqualification orders. Australian Companies Act 1981, s 227; and Singapore's Companies Act, s 154. Singapore Companies Act, s 155. For an excellent exposition regarding the section, see Hicks (note 57 above ). Professor Pillai, Singapore Select Committee Report, Report of the Select Committee on the Companies (Amendment) Bill, 12 June 1984 at A44. Despite criticisms, the Singapore government still saw automatic disqualification as an essential part of the proposal (the official response is at B20). See also the UK's Cork Report (note 62 above ) at paras 1817 and 1826, where the Cork Committee was also opposed to automatic disqualification despite the possible benefits. Hicks (note 57 above ) at 357 cites reports that in the first five months of 1985, company registrations in Singapore were at their lowest level of the decade (Big Drop in Number of New Companies Formed, Singapore Business Times, 10 June 1985). The Singapore Business Times cites the more stringent automatic disqualification rules of the amended Singapore Companies Act as the reason for this fall. Mr Justice Lightman (note 5 above ) at 125. Mr Justice Lightman (note 5 above ) at 125 draws a comparison with the driving-licensing system. See also Hicks (note 1 above ) at 42; and Finch (note 4 above ) at 390. Mr Justice Lightman (note 5 above ) at 125 Freedman, Small Businesses and the Corporate Form: Burden or Privilege? (1994) Modem Law Review 555. Note 4 above. Per Mr Justice Lightman (note 5 above ) at 125. Under the Singapore Companies (Amendment) Act 1984. Singapore Select Committee Report (note 65 above ) at B20 per Professor Jayakumar. Hicks (note 57 above ) at 356. For a further discussion on providing an alternative corporate form, see Freedman (note 70 above ) passim.
2013 Sweet & Maxwell and its Contributors

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69. 70. 71. 72. 73. 74. 75.