Directors' Duties — SQE1 FLK1 Business Law and Practice

Your client is the director who awards maintenance contracts at her company. The tender for the next three-year contract is still open. One of the bidders offers her £10,000, calls it a consultancy fee, and adds a fortnight's holiday for her family. The terms are plain: she is to see their bid home. She tells the board at once, and takes nothing. The board is relaxed, and asks you one question. Can we authorise her to keep it? No.

Not by any resolution the board can pass. Working out why takes you through most of this topic. This is Directors' Duties: seven statutory duties, a handful of section numbers worth real marks, and one distinction that decides half the questions. Keep your client and her £10,000 in mind.

Here is the route. Who counts as a director, and to whom the duties are owed. Then the seven duties in section order, from acting within powers to declaring an interest. Then what happens when one is broken: the remedies, ratification by the members, and relief from the court.

Start with the architecture, because here the section numbers are the content. Seven general duties, sections 171 to 177 of the Companies Act 2006. Around them, four more. s 170 says to whom they are owed. s 178, what follows when one is broken. s 239 is ratification by the members. s 1157 is relief from the court.

And here is the point that trips up more candidates than most. The duties are owed to the company. Not to the shareholders. s 170(1) says it in terms: the general duties in sections 171 to 177 are owed by a director to the company. The company is the proper claimant.

So who is a director? Wider than you think. In the Act, director includes any person occupying the position of director, by whatever name called. That is s 250. You cannot escape the duties with a different job title. De jure directors are appointed and registered at Companies House. De facto directors act as directors without any appointment, and owe every one of the duties.

Then shadow directors. s 251: a person in accordance with whose directions or instructions the directors are accustomed to act. Three years of written instructions carried out without question is the paradigm.

Two things are not shadow directorship. Advice given in a professional capacity, by a solicitor or an accountant, is expressly excluded. So is a bank imposing conditions to protect its loan, which the board weighs and accepts. Under s 170(5) the duties apply to a shadow director so far as they can.

s 171. Two limbs. Act in accordance with the company's constitution. And only exercise powers for the purposes for which they were conferred. Follow the rulebook, and do not misuse the powers it gives you. The second limb is the one that gets litigated.

Howard Smith Ltd v Ampol Petroleum Ltd, 1974. Directors issued new shares, diluting the majority shareholder's stake. The company had no need of the money. The real purpose was to defeat a takeover bid. The issue was invalid. Even though the directors honestly believed they were acting in the company's best interests, the power to issue shares exists to raise capital, not to manipulate control.

So good faith does not save you. Good faith answers s 172. It is no answer to the proper purpose limb. And the court asks what the substantial purpose was, not whether some proper purpose was in the mix.

s 172, usually called the most important of the seven. A director must act in the way 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. Read that again. In the way he considers. It is subjective: what this director believed, not what a court would have decided.

But he must also have regard to six listed matters. Long-term consequences. The interests of the employees. Relationships with suppliers and customers. The impact on the community and the environment. Maintaining a reputation for high standards of business conduct. And acting fairly as between members.

That is enlightened shareholder value. The members are the destination. Those six are factors to weigh on the journey, not interests that displace them, and they need not carry equal weight. A board that closes a plant after commissioning and discussing a report on the workforce and the town has done what s 172 asks.

Now the modification examiners love. When a company is in trouble, s 172(3) engages what is called the creditor duty, and the Supreme Court settled its trigger in 2022. It bites once the directors know, or ought to know, that the company is insolvent or bordering on insolvency. Or that an insolvent liquidation or administration is probable.

Note what is not enough. A real risk of insolvency at some future point does not engage it. That trigger was argued for and rejected. Once engaged, creditors' interests must be considered and balanced against the members', with more weight as the position worsens. They become paramount once an insolvent liquidation is inevitable.

s 173. Exercise independent judgment. Take advice, certainly, but make your own decision. The classic scenario is the nominee director, put on the board by an investor to protect the investor's interests. She owes her duties to the company, not to whoever appointed her. She may listen to her appointor. She may not vote as instructed without forming a view of her own.

And the duty is not infringed by acting in accordance with an agreement duly entered into by the company, or in a way the constitution authorises.

s 174. Reasonable care, skill and diligence, with two limbs working together. The care of a reasonably diligent person with, first, the general knowledge, skill and experience reasonably expected of a person carrying out the same functions. Objective. And second, the knowledge, skill and experience this director actually has. Subjective.

Why both? The objective limb is a floor: you cannot fall below basic competence by pleading ignorance. The subjective limb raises the bar for the expert, so a chartered accountant who becomes finance director is judged by what his qualifications make possible. You are held to whichever is higher.

Re D'Jan of London Ltd, 1994. A director signed an insurance proposal form without reading it. The form was wrong, the company claimed, and the insurer refused to pay. Negligent. A reasonably diligent director would have read it before signing, and he could not answer the charge by pointing at whoever put it in front of him.

Two riders. A non-executive is subject to exactly the same duty, but the objective limb measures her against the functions she actually carries out. And you may delegate, but you may not abandon oversight. Directors who sign blank payment authorities unread have fallen below any standard.

s 175. Avoid conflicts. A director must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company. It applies in particular to exploiting any property, information or opportunity. And note the sting: it is immaterial whether the company could have taken the opportunity itself.

Bhullar v Bhullar, 2003. Two directors learned that a property next to the company's own was for sale. Without telling the board, they bought it personally through a company of their own. The company had already resolved to buy no more property. Breach anyway. The opportunity came to them as directors, so it was for the board to decide.

The good news is that conflicts can be authorised. In a private company the board may authorise, unless something in the constitution invalidates it. In a public company the articles must expressly permit it. And the mechanics matter. It works only if the quorum is met without counting the conflicted director, and the decision is taken without his vote.

So try one. Three directors, model articles, quorum of two. The conflicted director and one colleague turn up and both vote in favour. Effective? No. Disregard him and one director attended. Inquorate, and the authorisation fails.

The conflict duty survives your resignation. Under s 170(2), a person who ceases to be a director stays subject to it for any opportunity he became aware of while in office. One director led negotiations for a contract, then heard privately that the client would take him but not his company. He resigned pleading ill health, signed the contract a month later through his own company, and had to account for every penny.

Which brings us back to your client and her £10,000. s 176: a director must not accept a benefit from a third party conferred by reason of being a director, or of doing anything as director. Bribes, kickbacks, secret commissions. And here is the answer to the board's question. Unlike a s 175 conflict, the board has no power to authorise a s 176 benefit. None.

The only relief is built into the section. The duty is not infringed if accepting the benefit cannot reasonably be regarded as likely to give rise to a conflict. So try another. A £2,500 weekend at a country hotel from a bidder while the tender is live. Or a £60 working lunch from a supplier who won a contract last year through a process she took no part in. Which can she keep?

The lunch. The weekend is lavish hospitality from a bidder in a tender she controls, which is precisely the conflict the section is aimed at. And taking the £10,000 would expose her and the bidder to prosecution under the Bribery Act 2010.

s 177, the last of the seven and the easiest to comply with. If a director is in any way, directly or indirectly, interested in a proposed transaction with the company, he must declare it. The nature and extent of the interest, to the other directors, before the company is committed. Indirectly is the word that catches people. A contract with a company owned by your spouse counts.

Four situations need no declaration. You are unaware of the interest or the transaction. It cannot reasonably be regarded as likely to give rise to a conflict. The other directors already know, or ought to. Or it concerns your own service contract, which the board will consider anyway.

And do not confuse s 177 with s 182. s 177 is the general duty and bites on proposed transactions. s 182 covers a transaction already entered into, and failing to declare under that one is a criminal offence.

Break a duty, and what follows? s 178 says the consequences are the same as would apply if the corresponding common law rule or equitable principle applied. In practice: damages, an account of profits, rescission, an injunction, and restoration of company property.

And the duties are cumulative. Under s 179 more than one can apply to the same conduct, which is your client again. Had she taken the money and steered the award, she would have breached four. s 176 by taking the benefit. s 175 by setting her interest against the company's. s 172 by getting worse terms. And s 177 by not declaring.

Regal (Hastings) Ltd v Gulliver is the case for the account of profits, and it is stricter than people expect. A director who exploits an opportunity that came to him as a director must account for the profit. It does not matter that the company lost nothing, or that it could not have taken the opportunity, or that he acted honestly and used his own money.

Then ratification. Under s 239 the members can forgive a breach by ordinary resolution. But the wrongdoer cannot forgive himself: the votes of the director, and of any member connected with him, are disregarded, and spouses and children are connected persons.

So work this one out. A sole director holds 55% and has sold a machine cheaply to his son's business. His son holds 10%. The other 35% is held by two members who will vote against. He proposes an ordinary resolution to ratify. Does it carry? No. Both his 55% and the 10% held by his son fall out of account, leaving only the 35% against.

One hard limit. Once the company is insolvent, the members cannot forgive conduct carried out at the creditors' expense. The value in the company is the creditors' by then, not the members' to give away.

Last, two safety valves. Under s 1157 the court may relieve a director from liability, wholly or in part. The test is that he acted honestly and reasonably, and ought fairly to be excused. And under s 232 a company cannot indemnify a director against liability to the company itself, though under s 233 it can buy directors and officers insurance.

A word on how SQE1 tests this. You will not be asked to recite a section number or a case name. You get a scenario, five answers, and one instruction: pick the best. What the numbers buy you is speed. Knowing a conflict is 175 and a third-party benefit is 176 tells you at once which authorisation rules apply.

If you keep only three. Howard Smith Ltd v Ampol Petroleum Ltd, for the rule that good faith does not cure an improper purpose. Bhullar v Bhullar, for the opportunity you must hand to the board even when you are sure they will not want it. And Re D'Jan of London Ltd, for the director who signed without reading.

Four traps. One: a s 175 conflict can be authorised by the board. A s 176 benefit cannot. Candidates mix those two constantly, and the whole answer often turns on which one you are in.

Two: a shareholder cannot sue in her own name for a fall in the value of her shares that merely reflects the company's loss. The duties are owed to the company. Her route is to ask the court for permission to bring a derivative claim on the company's behalf, under sections 260 to 264.

Three: there is no lower standard of care for a non-executive director. The same duty applies, measured by the functions she actually carries out. Four: watch the trigger for the creditor duty. Bordering on insolvency, or an insolvent liquidation probable. A real risk at some future point is not enough. Then a habit for the exam. Name the duty, name the section, ask whether it can be authorised or ratified, and only then reach for a remedy.

Quick check. Your client holds 15% of a private company and plays no part in running it. Over the past two years its two directors have committed it to contracts no competent board would have accepted, and her shares have lost two thirds of their value. The directors hold the rest of the shares and will not let the company sue. She wants her money back from them personally.

Three candidate answers. One: she may sue the directors herself, because the fall in her share value is her own loss. Two: she has no claim at all, because the court will not review a board's commercial judgment. Three: she cannot sue in her own right, but may seek the court's permission to sue on the company's behalf. Pause here if you want a moment.

The answer is three. The general duties are owed to the company alone, so the company is the proper claimant. A fall in share value that merely reflects the company's loss is not a separate loss she can recover.

Where the wrongdoing directors control the company and block any claim, there is a route. A member may ask the court for permission to bring a derivative claim on the company's behalf, under sections 260 to 264. Option one fails because the duties are owed to the company, not the members. Option two fails because terms no competent board would accept may well breach s 174.

Five things to take away. One: the duties are owed to the company, not the shareholders, which decides who can sue. Two: the section numbers do the work. s 171 powers, s 172 success, s 173 independent judgment, s 174 care, s 175 conflicts, s 176 benefits, s 177 declare.

Three: a s 175 conflict can be authorised by the board, if the quorum and the vote exclude the conflicted director. A s 176 benefit cannot be authorised at all, which is why your client cannot keep the £10,000. Four: on s 174 you are held to the higher of what the role demands and what your qualifications allow.

Five: good faith is a complete answer to s 172, and none at all to the proper purpose limb of s 171. Next time, Company Meetings and Resolutions.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.