Directors have traditionally enjoyed greater immunity from civil litigation than other professionals, for example accountants and solicitors, but that position of relative safety may be under threat following recent UK decisions relating to directors' liability, and recent Law Commission proposals for the reform of shareholders' remedies. Edward Smerdon reports.

Directors are now held more liable to account for their actions than ever before, not only by way of civil liability, but also by regulation (for example the Company Directors' Disqualification Act 1986), the criminal law, and the emergence of much publicised codes of conduct (for example Cadbury and Greenbury) which though not mandatory, directors ignore at their peril.

Public sympathy for directors has diminished as a result of a series of embarrassing corporate debacles in the City and news of fat cats and their lucrative share options, particularly in the privatised utilities, during the course of the last five years. There have also been a number of high profile directors' disqualifications, the most recent of which was that of Terry Venables. Perhaps these changing attitudes have to an extent influenced both recent trends in the liability of directors and the momentum for reform in relation to shareholders' remedies in the future.

Directors' duties to the company

Under UK law, it is well established that as an agent of the company a director owes a duty to the company and is liable for breaches of that duty. However, the standard of care expected of a director has until recently been relatively undemanding: directors must act with the care that a reasonably competent person in a similar position with similar skills and experience would exercise under similar circumstances, performing their duties in good faith in a manner they reasonably believed to be in the best interests of the company (Re City Equitable Fire Insurance Company [1925]). This suggested that errors of, for example, an inexperienced director would not be judged by the same standard of care as one who was more experienced. This could be contrasted with the general law relating to professional negligence in which a solicitor or auditor would be judged according to the standards of a reasonably competent member of his profession (Bolam v Friern Hospital Management Committee [1957]), so that inexperience, for example, would be no defence.

Re D'Jan of London Limited [1994] suggests that there is now a minimum standard of care below which a director's conduct may not fall. A liquidator brought an action on behalf of the company against the director and it was held by Lord Justice Hoffman, that the director was liable to the company, having acted negligently. Hoffman LJ ruled that the duty of care ordinarily owed by the director to the company was the same as in section 214(4) of the Insolvency Act 1986 relating to wrongful trading, that of:

"A reasonably diligent person having both - (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company and (b) the general knowledge, skill and experience that that director has."

An indication of the direction in which UK liability for directors may be going was given in the Australian case of AWA v Daniels [1995] (New South Wales, Court of Appeal). In a claim by the company against the auditors for allegedly failing to detect a hole in the company's accounts, the auditors alleged contributory negligence against the directors for mismanagement. It was held that certain directors were guilty of negligence and the company's damages were accordingly reduced. The relevant duty owed by the director was:

"a common law duty to take reasonable care and includes that of acting collectively to manage the company. Breach of the duty will found an action for negligence at the suit of the company."

This is effectively the same as the duty of care expected of any other professional at common law. UK law has yet to reach that level, but Re D'Jan indicates that the attitude evinced by UK Courts towards directors is hardening.

Directors' liabilities to third parties

A director is an officer of the company and the company will be liable for any negligent misstatement or misrepresentation made by the director to any third party while performing that role, under the principle in Hedley Byrne v Heller [1963].

The House of Lords, in Caparo v Dickman [1990] held that liability for negligent misstatements should be limited to situations in which the information (or mis-information) is used for a known and accepted purpose, the rationale being to limit potential claims for negligent misrepresentation to those who were sufficiently proximate and thereby to prevent any floodgates opening. However, courts have since been reluctant to dismiss claims against directors brought by third parties for misrepresentation, finding that such claims (at the very least) disclosed a reasonable cause of action (Morgan Crucible Co plc v Hill Samuel & Co Ltd [1991] (Court of Appeal)).

Traditionally, a director will not be personally liable for a misrepresentation he makes save in exceptional circumstances. In the Court of Appeal case of Williams v Natural Health Foods [1996], a misrepresentation was made by a company which induced a third party to enter into a franchise of a health food shop. A claim was initially brought by the third party against the company, but following its winding up, was pursued solely against its director and major shareholder notwithstanding that he himself had not made the misrepresentation. It was accepted that the company had been in breach of the duty of care it owed to the third party. The Court of Appeal held that:

1. to attach personal liability to a director, it must be shown that he assumed personal responsibility for the negligent misstatement made on behalf of the company, and

2. special circumstances must exist.

This director was held liable because he played a prominent role in the preparation of the financial projections which turned out to be misleading, and in the company's brochure, the director had held himself out as personally responsible for the figures to support those projections. It was this holding out which was the crucial special circumstance necessary to find the director personally liable.

It is likely to be increasingly argued by injured third parties that the director should be personally liable where the company is insolvent, if he is the only deep pocket left. The fact that the director himself either has substantial assets or D&O insurance (the existence of which may be ascertainable from the company accounts), may encourage third party claimants.

Exceptionally, a director may be personally liable for other wrongs committed by the company. In Royal Brunei Airlines v Philip Tan Kok Ming [1995] (Privy Council), the managing director of a company, who was also the principal shareholder, was found liable for a breach of trust committed by the company, as, in the view of the court he "was the company, and his state of mind is to be imputed to the company". He was found to be guilty of knowingly assisting the breach of trust and was unable to hide behind the "corporate veil" in relation to dealings with third parties. The court here was clearly influenced by the fact that this director was effectively the "alter ego" of the company, and therefore should not escape liability for his own dishonest acts.

Liabilities of a director to shareholders

The general rule was established in the case of Foss v Harbottle [1843], namely, that a director owes a duty to the company and not to its shareholders and as such, shareholders are unable to claim directly against the directors for breach of duty. To this rule there are, at present, two principal exceptions:

1. Section 459 Companies Act 1985 - a shareholder may apply to the court on the basis that the company is being run in a manner which is unfairly prejudicial to the interests of that shareholder. The action does not, however, per se constitute a claim against the directors.

2. Fraud on the minority - the majority of shareholders may bring a derivative action against the directors in the name of the company. Minority shareholders have no such rights, except in circumstances where there has been an alleged fraud on that minority interest committed by the directors. In view of the difficulty of proving fraud and the limited scope of this exception to the general rule, this option is rarely exercised.

However, the Law Commission has been examining the whole area of shareholders' remedies and tentative recommendations are made for reform in its report of October 1997. The important proposal, from the point of view of directors' liabilities, is the abolition of the restriction that prevents shareholders from bringing claims against the directors where they have been clearly negligent but not fraudulent.

The new derivative action proposed, would be subject to the following guiding principles:

(i) the right to sue would arise only where there was an actual or threatened act or omission involving negligence, breach of duty/trust by a director or where the director put himself in a position of conflict of interest;

(ii) it would replace the common law fraud on the minority derivative action entirely;

(iii) before the procedure could be invoked, the shareholder claimant would have to give notice to the company of his intention to bring the action at least 28 days prior to commencing proceedings, specifying his grounds; and

(iv) the case would be strictly controlled by the court. This would involve a case management conference soon after the action is brought, at which leave would be required for the continuance of the claim, the aim being to prevent frivolous actions.

Therefore, minority shareholders would be able to bring derivative actions against the directors for clear mismanagement in circumstances where currently only majority shareholders can. This would be potentially significant where the directors themselves were majority shareholders.

Directors' disqualification

There has recently been a spate of disqualifications under Section 6 of the Company Directors Disqualification Act. The courts have extremely broad powers to disqualify directors which they are using increasingly frequently: in 1986/87, just after the Act came in to force, there were just 16 disqualifications. This figure rose to 497 in 1992/93 and again to a massive 903 in 1995/96. Recently the following guidelines were laid down by the Court of Appeal in Secretary of State for Trade and Industry v Griffiths and Others [1997]:

1. directors' duties involve inescapable personal responsibilities;

2. although the primary purpose of disqualification of directors is to protect the public, there must also be an element of deterrence;

3. a common sense approach to case management would be adopted so as to confine the evidence to that which was probative.

A wide variety of matters, including the former director's age and state of health, length of service, whether he had admitted the offence, his general conduct before and after the offence, and periods of disqualification of any co-directors might be relevant in determining the appropriate ban.

Conclusions

While we still have some way to go before directors in the UK are as readily exposed to claims as their counterparts in the United States, recent developments seem to indicate that:

1. the standard of care expected of a director in his duty to the company is increasing;

2. the ambit of a director's liability to third parties has been widened; and

3. shareholders may in future have greater rights to bring derivative actions against the directors, although in tightly controlled circumstances.

Against that background, how can a director minimise the risk of damaging claims? Wherever possible, he should follow established codes of conduct, and purchase D&O liability insurance, a developing, and relatively inexpensive cover available in the London insurance market.

Edward Smerdon is an associate, DAC Professional Indemnity and D&O group.