Company Lawyer

2007

Legislative Comment Section 172(1) of the Companies Act 2006: an interpretation and assessment
Andrew Keay

Introduction
At long last we have a new Companies Act on the statute books. On November 8, 2006 the royal assent was given to the Companies Act 2006 (the Act). Most of the statute is not in force as yet, with parts of it being put into force over the next year or so, with completion of this process being set at October 2008. It all began with the commissioning in March 1998 by the Department of Trade and Industry of a review that was ultimately to formulate proposals for the reform of UK company law.1 The review was to be overseen by a committee that became known as the Company Law Review Steering Group (CLRSG). The CLRSG published several substantive papers that set out its views and asked questions, thereby soliciting feedback. In July 2001 it submitted a Final Report to the Secretary of State for Trade and Industry. Subsequently, the Government drafted two White Papers that provided its response to the CLRSG's Final Report. After receiving feedback from the community the Government introduced into Parliament in November 2005 the Company Law Reform Bill 2005. The Bill was subjected to considerable debate in both Houses of Parliament and was re-branded as the Companies Bill 2006, before it finally became an Act in late 2006. The new legislation seeks to do many things, including modernising our company law, which is effectively based on 19th-century foundations. Arguably one of the most important aspects of the new statute is the codification of the duties of directors.2 The Parliament has taken this opportunity, on the recommendation of the CLRSG, to amend common law rules and equitable principles, although the codified duties will draw on common law rules and equitable principles. As part of the codification, Parliament has decided to introduce a broad duty that is to guide directors in determining what the objective of their activities should be. This latter duty is found in s.172(1), and it is obviously a pivotal part of the legislation as far as it deals with directors and their duties. Arguably, it is also of importance to thinking on wider issues in corporate governance. This article seeks to explore a number of questions that the drafting of the subsection precipitates, especially in terms of interpretation and application.

The emergence of s.172(1)

For the first time UK companies legislation provides what the objective of the directors, in conducting the affairs of the company, is to be. Hitherto, it has been left to the courts to make this determination. While the case law has generally stated that the directors are to act in the best interests of the company, it has not been unequivocal as to what is the meaning of this objective. Section 172(1) purports to do that. It provides: A director of a company must act in a way that he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to-(a) The likely consequences of any decision in the long term (b) the interests of the company's employees (c) the need to foster the company's business relationships with suppliers, customers and others (d) the impact of the company's operations on the community and the environment (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly between the members of the company. Before considering the meaning and application of the provision, it is quite instructive to see how it originated and developed.

In its review, the CLRSG saw the issue concerning in whose interests companies should be conducted as a central one.3 It identified two possible approaches to addressing the issue, namely either a shareholder value approach or a pluralist approach.4 The CLRSG noted that shareholder value has generally been implemented in the United Kingdom, and noted that the issue of for whose benefit a company should be managed has been widely debated. The CLRSG stated5 that the present law reflects the fact that companies are managed for the benefit of the shareholders, and it confers on the shareholders ultimate *Comp. Law. 107 control of the undertaking, such that [t]he directors are required to manage the business on their behalf .6 It went on to say that the ultimate objective of companies is to generate maximum wealth for shareholders.7 The pluralist or stakeholder approach requires, inter alia, that directors are to conduct the affairs of the company for the benefit of all stakeholders, and they should balance the interests of a multitude of stakeholders (including the shareholders) who can affect or be affected by the actions of a company. The CLRSG ended up proposing, in its Final Report, an approach which it referred to as enlightened shareholder value, and which it felt would better achieve wealth generation and competitiveness for the benefit of all. This approach is clearly based on shareholder value and involves directors having to act in the collective best interests of shareholders,8 but does not support exclusive consideration of short-term financial benefits; rather it seeks a more inclusive approach that values the building of long-term relationships.9 The concept of the enlightened shareholder value approach was adopted by the Government in its White Papers of July 2002 and March 2005, the Company Law Reform Bill 2005 and ultimately the Act. Clause 19 of a draft Bill included in a White Paper in July 200210 stated that Sch.2 to the draft Bill set out the general principles by which directors were to be bound. Paragraph 2 of the Schedule stated that A director of a company must in a given case-(a) act in the way he decides, in good faith, would be the most likely to promote the success of the company for the benefit of its members as a whole; and (b) in deciding what would be most likely to promote that success, take account in good faith of all the material factors that it is practicable in the circumstances for him to identify (emphasis added). The paragraph then went on to enumerate the material factors. In a second White Paper entitled Company Law Reform 11 and published in March 2005 there were some interesting changes in how the approaches advocated in the CLRSG's Final Report and the first White Paper would be implemented. Relevantly, as far as we are concerned, the later White Paper provided, as with the earlier one, that there are two elements to be considered in the way in which directors are to run the company.12 First, they are to do that which they consider, in good faith, is most likely to promote the success of the company for the benefit of the members as a whole. Secondly, in carrying out the first element, the directors are to take into account, where relevant, and as far as is reasonably practicable, several factors (in order to reflect wider consideration of responsible business behaviour) that were listed, but not intended to be exhaustive. The factors enumerated in cl.B3 of the draft Company Law Reform Bill that was part of the White Paper were stated to be: (a) The likely consequences of any decision in both the long and the short term (b) any need of the company-(i) to have regard to the interests of its employees (ii) to foster its business relationships with suppliers, customers and others (iii) to consider the impact of its operations on the community and the environment, and (iv) to maintain a reputation for high standards of business conduct. The directors also had to consider the need to act fairly as between members of the company who have different interests. Clause B3 indicated that the long-term performance of the company has to be considered by directors, and an array of interests of those who might be categorised loosely as stakeholders.

On November 1, 2005, the Company Law Reform Bill was introduced into the House of Lords. Clause B3 in the draft Bill included with the Second White Paper had now become cl.156. Clause 156(1) and (3) stated: (1) A director of a company must act in a way that he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members as a whole. (3) In fulfilling the duty imposed by this section a director must (so far as is reasonably practicable) have regard to-(a) The likely consequences of any decision in the long term (b) the interests of the company's employees (c) the need to foster the company's business relationships with suppliers, customers and others (d) the impact of the company's operations on the community and the environment (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly between the members of the company. With a minor change in the order of the terms of the provision and the omission of the words so far as is reasonably practicable this provision effectively became s.172(1) of the Companies Act 2006.

Interpreting s.172(1) Discretion

The first thing to note about the provision is that it grants an unfettered discretion to the directors provided that they act in a way that they consider would most likely promote the success of the company for the benefit of the members. Prima facie there are no objective criteria that can be used to assess what the directors have done. Earlier, in the 2002 draft Bill, it was provided in cl.2(b) of Sch.2 that in deciding what would be most likely to promote that success [of the company], [a director must] take account in good faith of all the material factors that it is practicable in the circumstances for him to identify. Material factors were defined as: *Comp. Law. 108 (a) The likely consequences (short and long term) of the actions open to the director, so far as a person of care and skill would consider them relevant; and (b) All such factors as a person of care and skill would consider them relevant. Section 172(1), as did the relevant clause in the Company Law Reform Bill (cl.156), omitted any reference to the fact that the directors are to consider the factors that a person of care and skill would consider relevant. Nevertheless, and somewhat surprisingly, the Guidance on Key Clauses to the Company Law Reform Bill stated that in having regard to the factors in cl.156 directors must comply with their duty to exercise reasonable care, skill and diligence.13 There is no explanation for the fact that the Government removed the words that were included in the draft Bill in the 2002 White Paper, so far as a person of care and skill would consider them relevant.

Have regard to
Directors are obliged, in the course of acting in the way that is most likely to promote the success of the company for the benefit of the members, to have regard to matters mentioned in s.172(1). But there is no explanation in the Act as to what is meant by the fact that a director is to have regard to the interests, or how directors are to consider such interests of the members in the decisions that they are making. Are directors merely to take the interests of constituencies other than those referred to in s.172(1) into account in so far as this promotes benefits to shareholders or does it enable, or even require, directors to be concerned with such interests as ends in themselves? The background to the provision, together with the way that it is drafted, suggests that the former interpretation is probably correct. It is noteworthy that s.172(1) does not, when it lists the matters to which the directors are to have regard, purport to be exhaustive. It states that the directors are to have regard to (amongst other matters) and then lists some matters. What are these other

matters likely to be? It is difficult to say, for s.172(1) refers to the stakeholder interests to which reference is often made when debating the objective of companies and whose interests the directors should consider, and these are employees, suppliers, customers and the community. There is no reference to creditors, other than suppliers. This constituency might be covered by the catch-all others in s.172(1)(c), but if that is envisaged then it is perhaps strange that creditors were not expressly mentioned. It might be said that the reason that they are not mentioned is that they are protected by s.172(3), which provides that the duty imposed by s.172 is subject to any rule of law requiring directors in certain circumstances to take into account the interests of creditors. This is a clear reference to the case law that has developed over the past 20 years in the United Kingdom and elsewhere and which provides that if a company is in some form of financial difficulty the directors must consider the interests of creditors in the decisions which they make.14 Creditors might respond that this does not protect them sufficiently, but that is another issue. The fact is that it really does not matter what is a good result for any of the constituencies mentioned in the provision, after directors have had regard for these interests, for the ultimate concern of directors is that their action promotes the success of the company for the benefit of the members as a whole.

Good faith
Section 172(1) states that directors must act in the way that they consider is most likely to promote the success of the company for the benefit of members, and the consideration undertaken by the directors is to be in good faith. During the evolution of s.172(1) the issue of good faith has been integral. While the Guidance on Key Clauses published when the Company Law Reform Bill was introduced into Parliament states that in having regard to the factors enumerated directors must comply with their duty to exercise reasonable care, skill and diligence,15 it went on to say that the decision as to what will promote success [of the company], and what constitutes such success, is one for the directors' good faith judgment. This ensures that business decisions on, for example, strategy and tactics are for the directors, and not subject to decision by the courts, subject to good faith.16 The difficulty with this is that there are no definite standards against which the actions of directors can be assessed. Directors can merely say that they acted in good faith, and their position then becomes virtually unassailable. The Guidance states that it will not be sufficient to pay lip service to the factors. Yet it might well be difficult to prove that directors have just paid lip service to the requirements in s.172. The courts have said previously, in considering claims made against directors that they acted in breach of their duty to act bona fide in the best interests of the company, that it was a problem merely having a subjective test for determining whether a director had breached the duty. As a result objective considerations were introduced by courts to supplement the subjective test. In Charterbridge Corp Ltd v Lloyds Bank Ltd, 17 Pennycuick J. said that the court had to ask whether an intelligent and honest man in the position of a director of the company involved, could, in the whole of the circumstances, have reasonably believed that the transaction was for the benefit of the company.18 If that interpretation is not imported to a judicial consideration of s.172(1), there seems little to stop directors from asserting that they considered, in good faith, the interests of constituencies, but thought that what was done was appropriate. Consequently, it might be submitted that the old cases should be applied to guide the proper application of the law.19 The problem with this is that the legislation unequivocally refers only to a subjective test. Nevertheless, it is contended that given the fact that the legislation states expressly in s.170(3) and (4) that *Comp. Law. 109 [t]he general duties are based on certain common law rules and equitable principles The general duties shall be interpreted and applied in the same way as common law rules or equitable principles, and regard shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties. Parliament impliedly accepted, knowing the state of the common law, that the courts would introduce objective considerations into an assessment of a director's actions.

The success of the company

The first thing to note is that there is no indication in s.172(1) as to the meaning of the success of the company, an issue which attracted substantial criticism from the Law Society when it responded to the March 2005 White Paper.20 What will be the criteria used for judging whether the action of the directors led to the success of the company? It might well be argued that the directors' action does not necessarily need to lead to success in objective terms, whatever they might be, provided that the directors in good faith believed that the action which they took would be most likely to promote the success of the company. The reason is that according to the Guidance on Key Clauses in the Company Law Reform Bill,21 and as indicated previously, the decision as to what will promote success, and what constitutes such success, is one for the directors' good faith judgment. This ensures that business decisions on, for example, strategy and tactics are for the directors, and not subject to decision by the courts, subject to good faith.22 Section 172 does not require directors to give any guarantee of success and there is no reasonable care requirement contained in the section. Yet it might be contended that if directors took action which did not lead to the success of the company and the action could be regarded as lacking care and skill, the directors could be held liable for a breach of s.174, a provision which codifies the present common law duty of care and skill. This conclusion seems to accord with what was stated in the Guidance on Key Clauses to the Company Law Reform Bill. It said that directors are required to have regard to the factors that are now listed in s.172(1), and in doing so, their duty to exercise reasonable care, skill and diligence will apply.23 The test as to whether directors have met the obligation in s.172(1) is whether the directors considered in good faith that their action would be most likely to promote the success of the company for the benefit of the members as a whole. The expression members as a whole has been used on several occasions in company law and, consequently, one would assume that the judicial comments on the meaning of the expression would be pressed into service here. The courts have tended to hold that it means the present and future shareholders.24

Commencing actions for breach

If someone who is a member of one of those constituents that are referred to in s.172(1) is of the view that directors have breached the provision in that they, the directors, failed to have regard for the interests of his or her constituency, is that person able to take any legal action against the directors? The plain answer appears to be no, certainly under the Act. This has been one of the problems with s.309 of the present legislation, as acknowledged by the CLRSG in its deliberations.25 This section requires directors to consider the interests of employees in determining what is in the best interests of the company. Most, if not all, have accepted the fact that s.309 is something of a lame duck,26 and next to useless. The provision has hardly been used and there is very little case law on the section. It has been said that a right without a remedy is worthless,27 so this causes one to ask whether a breach of s.172(1) can be subject to any proceedings, and therefore whether s.172(1) has any teeth, certainly as far as nonshareholders are concerned. The only stakeholders in the company who are able to take action under the Act appear to be the shareholders. Shareholders are, under the Act, given the right to bring derivative proceedings (subject to court approval) against directors in respect of a cause of action vested in the company (s.260(1)(a) of the Act). So, if directors fail to comply with s.172(1) in some way, does that lead to a claim that is vested in the company so that the members could initiate derivative proceedings? It would appear that the answer is in the affirmative given the fact that s.l 78 provides that the consequences of breaches of ss.171-177 are the same as would apply with the corresponding common law rules or equitable principles. Under these rules and principles a right of action would redound to the company where directors breached one of their duties. Also, s.260(3) of the Act provides that a derivative claim may be brought only in respect of a cause of action arising from an actual or proposed act involving, inter alia, a breach of duty by a director

of the company. Hence it would seem that a cause of action would vest in the company, within the meaning of s.260, and members would be entitled to commence derivative proceedings. This is confirmed by s.178(2) when it states that, duties in those sections [171-177] are, accordingly, enforceable in the same way as any other fiduciary duty owed to a company by its directors. Therefore, if directors breach s.172(1), the members could seek to take action on the part of the company. One could envisage them doing so if the directors either fail to act so as to promote the success of the company for the benefit of the members or fail to have regard for the need to act fairly as between members (s.172(1)(f)), but this is not so likely to occur, if at all, in circumstances where the directors fail to have regard for the other interests adumbrated in s.172(1), especially when one takes into account the fact that there is likely to be a cost element in any derivative claim. There are only a few situations where one could envisage an *Comp. Law. 110 action being brought by a member other than in the cases mentioned above. First, where a member invested in the company for the long haul, and he or she feels that the action of the directors does not have regard for the long term. The member might feel that the directors are overly myopic and that could well mean that the member will receive less in the long run. Secondly, a member is also an employee of the company and is concerned that the directors did not have regard to the interests of the employees. Thirdly, a member is concerned that the directors have not had regard for the need to promote business relationships with suppliers, customers or others and it is likely to damage the company in the future. Fourthly, there are members of the company living in the community in which the company operates, and they believe that the community will be adversely affected by the actions of the directors, and that will, as a consequence, affect the lives of those members. An example might be where a company which operates several factories decides to close one that is in the community where a member resides or has other business interests. Fifthly, a member has concerns wider than his or her own interests and feels obliged to take proceedings because of a heightened sense of community interest, and he or she believes that directors failed to consider community interests in the decisions which they have made. The upshot is that except where one has a member with a social conscience, the only likely derivative proceedings are those brought by members whose self-interest in another capacity will be affected deleteriously in some way. Even if derivative proceedings are commenced, directors might well argue that they did have regard for all of the matters mentioned in s.172(1)(a)-(f) and simply believed that what they did promoted the success of the company for the benefit of the members. If so, as indicated earlier, it might well be difficult for a member to challenge such an assertion successfully, and to establish that the directors did not have regard for the relevant matters. Of course, the company might end up in administration or liquidation, and the administrator or liquidator will be able to take action against the directors for a breach of s.172(1), but it is likely at this stage (and it might depend on the period of time between the controversial decision of the directors and the entry into administration or liquidation) to be difficult to establish that the directors should not have done what they did. First,28 any administrator or liquidator would have to impugn successfully any claim on the part of the directors that they had acted in good faith in a way that was most likely to promote the success of the company for the benefit of members. Secondly, the courts have made it plain that they will not use hindsight in making their decision when assessing the actions of directors,29 and it might be argued, certainly when one studies the cases involving claims of wrongful trading under s.214 of the Insolvency Act 1986, that courts have tended to place a benevolent interpretation on what directors have done, and they have not found them liable save where they have acted in a completely irresponsible manner.30 Perhaps the only possible action available to those who make up the constituencies covered in s.172(1) might be to seek injunctive relief, in an attempt to prevent directors from doing something where the directors have failed to have regard to the matters set out in the subsection. It is questionable whether a court would accede to the application

of a non-member, and even if they did, the courts would have to consider evidence in order to make a decision as to whether directors did intend to act appropriately and this would be far from easy at an interlocutory stage. It is more likely that non-member stakeholders will have to rely on rights that are provided for outside of company law, and certainly this is where the CLRSG thought that stakeholders' safeguards lay.31 For instance, creditors are protected if directors engage in wrongful trading, in breach of s.214 of the Insolvency Act. But, as the author has argued elsewhere,32 these give partial and imperfect cover to stakeholders and only allow for some sort of remedy or relief ex post, while protection ex ante is often needed in order for it to be truly effective.

Conclusion
Section 172(1) is an interesting innovation in that it provides, for the first time, a legislative mandate as to for whose interests directors are to act in their management of the affairs of companies. How the provision is applied might well depend on a number of factors. Perhaps the main point to note is that there does not seem to be any framework in place to ensure that directors are held accountable for their decision-making process. As it is there are likely to be few occasions, if any, where a director is going to have to justify what he or she did. Of course, very often, and especially with what might be regarded as the daily affairs of the company, those constituencies who are mentioned in s.172(1) will not know what the directors have done, and when they do, it will too late to do anything that is effective. Members might be able to institute derivative proceedings against directors where there is thought to be a breach of s.172(1), but save where directors have failed to benefit the members from the action that they have taken, such proceedings are likely to be few and far between. Those who are numbered among other constituencies in the provision will not be entitled to initiate any legal proceedings against directors, so where directors fail to have regard for the interests set out in the subsection, it is unlikely that they will called to book. As a consequence it is questionable whether the hope of the CLRSG that the law will achieve wealth generation and competitiveness for the benefit of all will come to fruition. Andrew Keay Professor of Corporate and Commercial Law, Centre for Business Law and Practice, School of Law, University of Leeds Comp. Law. 2007, 28(4), 106-110
1. Company Law Review, Modern Company Law for a Competitive Economy (DTI, 1998), p.1. 2. See ss.171-177 of the Act. 3. See Company Law Review, Modern Company Law for a Competitive Economy: The Strategic Framework (DTI, London, 1999), para.5.1.1. 4. These are explained in A. Keay, Enlightened shareholder value, the reform of the duties of company directors and the corporate objective [2006] L.M.C.L.Q. 335. 5. Above fn.3, para.5.1.4. 6. ibid. , para.5.1.5. 7. ibid. , para.5.1.12. For a consideration of this concept, see, for example, S. Bainbridge, In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green (1993) 50Washington and Lee Law Review 1423; D Gordon Smith, The Shareholder Primacy Norm (1998) 23 Journal of Corporate Law 277; M. Roe, The Shareholder Wealth Maximization Norm and Industrial Organization (2001) U. Pa. L.Rev. 2063; S. Bainbridge, Director Primacy: The Means and Ends of Corporate Governance (2003) 97 Northwestern University Law Review 547; Keay, above fn.4. 8. Company Law Review, Modern Company Law for a Competitive Economy: Developing the Framework (DTI, London, 2000), para.2.22.

9. ibid. 10. Modernising Company Law , Cm 5553, DTI. 11. Company Law Reform , Cm 6456, DTI, 2005. 12. ibid., Explanatory notes at para.B17. 13. Guidance on Key Clauses to the Company Law Reform Bill (DTI, 2005), para.63. The Guidance can be found at www.dti.gov.uk. 14. See A. Keay, Company Directors' Responsibilities to Creditors (Routledge-Cavendish, London, 2007), pp.151 et seq. 15. Above fn.13. 16. ibid. , para.64. 17. [1970] Ch.62; [1969] 3 All E.R. 1185. 18. ibid. , 75; 1194. Also, see Shuttleworth v Cox Bros (Maidenhead) Ltd [1927] 2 K.B. 9 at 23. 19. See S. Worthington, Reforming Directors' Duties (2001) 64 M.L.R. 439 at p.456. 20. Above fn.11. The Law Society response was published in June 2005. The criticism was set out on p.34 of the Response. 21. Above fn.13, para.64. 22. Above fn.13. 23. ibid. , para.63. 24. For instance, Gainman v National Association for Mental Health [1971] Ch. 317 at 330; Brady v Brady (1987) 3 B.C.C. 535 at 552, CA. 25. Above fn.3, para.5.1.21. 26. For example, see L. S. Sealy, Director's Wider Responsibilities--Problems Conceptual Practical and Procedural (1987) 13 Monash University Law Review 164 at p.177. 27. M. McDaniel, Bondholders and Stockholders (1988) 13 Journal of Corporation Law 205 at p.309. 28. The author first made these points in the article mentioned above fn.4. 29. For instance, see Re Welfab Engineers Ltd [1990] B.C.C. 600; Re Sherborne Associates Ltd [1995] B.C.C. 40. 30. For example, see Re Continental Assurance Co Ltd [2001] B.P.I.R. 733; The Liquidator of Marini Ltd v Dickensen [2003] EWHC 334 (Ch.); [2004] B.C.C. 172. 31. Company Law Review, Modern Company Law for a Competitive Economy: Developing the Framework (DTI, London, 2000), para.2.12. 32. Above fn.4.