Balancing the interests and obligations of In-House Lawyers and Directors

There is an increasing trend for companies to appoint Legal Directors, whose duties will extend beyond the traditional role of In-House Counsel. With this in mind, we summarise the current regime of directors duties and then explore the role of In-House Counsel as Legal Director.

1. Directors’ Duties under the Companies Act 2006

Firstly, a brief recap of the relevant sections 170 to 177 of the Companies Act 2006 (“CA”), which codified the nature and scope of directors’ duties, replacing but also building on the principles of fiduciary duty established under the common law and equity. Pre-CA caselaw concerning directors duties remains in many cases relevant and directly applicable.

Duties are owed to the company itself, not to individual shareholders or other parties (except in insolvency situations where the duties may be owed to creditors). As a result, breaches of directors’ duties are in most circumstances only enforceable by the company itself in proceedings initiated by the directors on behalf of the company, subject to the rights of a shareholder bringing a claim in the name of the company (a derivative action under Part 11 CA) or issuing a petition for relief for unfair prejudice under s.994 CA.

A director in breach of his duties may be liable to pay compensation to the company, restore property, rescind a transaction and/or account to the Company for any profits he had made.

1.1. General Duty to Act within Powers (s171 CA)
A director must act in accordance with the company’s constitution and must only exercise powers for the purpose for which they are conferred. Unless expressly permitted by the CA (such as s. 180(4)(b), which provides that a director will not be in breach of duty if he acts in accordance with any provisions in the company’s articles for dealing with conflicts), the company’s constitution cannot override duties imposed by the CA. The question of whether powers are exercised for “proper” purposes will require consideration of the context and the motivations of the director.

1.2. Duty to Promote the Success of the Company (s172 CA)
Directors must act in a way in which they consider in good faith would be most likely to promote the success of the company for the benefit of its members as a whole (rather than for the benefit of specific, or a specific class of, shareholders), having regard to (amongst other things):
• the likely consequences of any decision in the long term;
• the interests of the company’s employees;
• the need to foster business relationships with suppliers and customers;
• impact of operations on the community and environment;
• desirability of maintaining a reputation for high standards of business conduct; and
• the need to act fairly as between the members of the company.
This duty is displaced if the company becomes, or is about to become insolvent, at which time the directors must have regard to the interests of the creditors of the company.

As set out above, the duties are owed to and enforceable by the company, rather than any third party stakeholders so there are question marks over how likely it is that this duty will be enforced. The most likely scenario would be by activist shareholders under a derivative action, or by a liquidator in a misfeasance claim.

1.3. Duty to Exercise Independent Judgment (s173 CA)
A director should not blindly act upon the instructions of another or, indeed, upon professional advice without exercising independent judgment . This duty is not infringed by acting in a way authorised by the company’s constitution or in accordance with an agreement duly entered into by the company restricting the future exercise of discretion by directors.

1.4. Duty to Exercise Reasonable Care, Skill and Diligence (s174 CA)
Directors must exercise reasonable care, skill and diligence. They must show the skill they actually have or that which might reasonably be expected of a director in their position, whichever is higher. A director who has 30 years’ experience as an accountant will therefore be expected to exercise the skill, care and diligence of a 30 years’ qualified accountant, whilst a director cannot rely on his own professed lack of ability or understanding to fall below the standard reasonably expected of a director in such a company. However, directors will not be held to be liable without more simply because the company has suffered a loss as a result of their conduct.

1.5. Duty to Avoid Conflicts of Interest (s175 CA)
Directors must act in such a way as to avoid a situation in which they have, or could have, an interest which conflicts with the interest of the company. Directors have a duty to inform the company of relevant business opportunities and will be liable for obtaining an opportunity for himself irrespective of whether he acts in good faith or whether the company could, or might, have taken advantage of the property, information or opportunity in question.

1.6. Duty not to Accept Benefits from Third Parties (s176 CA)
A director must not accept a benefit from a third party conferred by reason of his being a director or his doing or not doing anything as a director. There is effectively a de minimis provision as the duty will not be infringed if the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest.

1.7. Duty to Declare Interest in Proposed Transactions (s177 CA)
If a director is in any way, whether directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors before the company enters into that transaction or arrangement. However, a director need not declare an interest if it cannot reasonably be regarded as likely to give rise to a conflict of interest or if the other directors are, or ought reasonably to be, aware of it.

1.8. Ratification of Acts of Directors and Relief from Liability
A company cannot exempt a director from breach of his duties, and it cannot indemnify him for liability (except as specifically provided for by s232(2) CA concerning provision of insurance, third party indemnities and pension scheme indemnities). However, the members of the company (excluding, if applicable, the director in question and any connected person) can ratify a breach of duty by director in relation to conduct concerning the company, unless that breach was illegal or fraudulent.

The Court may grant relief from liability under s1157 CA if the director acted honestly and reasonably and, having regard to all the circumstances, ought fairly to be excused.

2. Who is a Director?
All persons who are validly appointed as a director (so called de iure directors) of the company will of course be subject to the statutory duties set out above. However, directors’ duties may also apply to persons who are not formally appointed as directors if they nevertheless directly or indirectly direct or control the company. Such persons are typically split into two categories, de facto directors and shadow directors, although the two definitions may overlap to an extent.

A de facto director is someone who, though not validly appointed as a director of a company, exercises the functions of a director and is held out to be a director. In many cases such a person will be referred to as a director both within the company and to customers and suppliers, who will not be aware that the person has not been formally appointed as a director. It will depend on the facts of each case whether any given person is a de facto director, and the nature of the activities undertaken. The label of ‘director’ is not of itself conclusive. A person who continues to act as a director cannot escape his directors’ duties by virtue of having resigned his title.

A shadow director is defined by s251(1) CA as a person in accordance with whose directions or instructions the directors of the company are accustomed to act. Whilst the shadow director must exercise a real influence, a person will not be regarded as a shadow director simply because the directors rely on professional advice given by that person, but this does not mean that a professional advisor cannot dependent of the nature of his activities be held to be a shadow director. Typically a shadow director may be a shareholder who (for whatever reason) does not want to be formally appointed as a director but effectively controls the company. A lender which seeks to involve itself in the decisions of a corporate borrower (particularly likely where the company is in danger of insolvency) may also risk being deemed to be a shadow director.

Importantly, claims for breach of statutory duties may be brought against de facto and shadow directors.

3. The Role of In-House Counsel
Historically, in-house counsel have offered discrete legal advice to directors and attendance at board meetings has been in a limited and often observatory capacity (perhaps restricted to taking board minutes). However, the role of In-House Counsel is, in some companies at least, changing. Due no doubt to the financial pressures brought about by the economic downturn in 2008 and the resulting decisions to cut down on the use of external lawyers, in-house counsel have become less a conduit for obtaining legal services and more a core part of the decision making process, providing advice which involves a consideration of commercial issues in addition to strict legal considerations.

Whilst this enhanced role can offer exciting challenges and opportunities extending beyond the traditional activities, it will also give rise to a number of new considerations, particularly in relation to interaction with the board and the possibility of conflicting duties.

3.1. The Legal Director
An increasing number of companies have appointed a legal director. The challenges posed by increasing globalisation including the requirement to understand a multitude of regulatory, jurisdictional and enforcement regimes mean that legal input is required at a strategic, prospective level, rather than simply being provided reactively in response to discrete issues as and when they arrive.

In time such a role may be seen as essential to the fundamental governance of a company as a financial director, although at this stage it remains a relatively novel appointment. Even if not formally appointed as a de iure director, in-house counsel may find that their involvement in the decision making process of the company and the nature of their day to day activities means that they are subject to the directors’ duties outlined above.

There is likely to be a tension in this enhanced role of Legal Director between the inherent risk taking that may be said to be a characteristic of successful directors and the requirement for in-house counsel to maintain the legal and ethical standards of the company. The duties of in-house counsel imposed by virtue of their position as a lawyer may conflict – or at least appear to conflict in the eyes of the other directors – with the imperative for commercial performance. Of course, the duty to promote the success of the company will never oblige a director to act unlawfully, but the specific knowledge of in-house counsel and the duty to ensure the company complies with its obligations may mean there is a risk that the Legal Director will be seen as placing obstacles and stifling creative thinking, rather than providing the solutions required by the board.

The role as legal director is also likely to raise some interesting questions as to the ability of in-house counsel who is also a director to provide impartial advice to the company. If an in-house counsel Legal Director approved a particular transaction, are they in a position impartially to advise the company in a dispute arising out of that transaction? This issue is likely to be particularly acute where there are allegations of breach of directors’ duties.

In-house counsel Legal Directors must take care to preserve privilege in respect of legal advice provided to the company, particularly at board meetings where it may not be entirely clear which “hat” is being worn at any particular time. A clear distinction must be drawn (and be shown to be drawn by, for example, separately labelling legal advice and not including it within board minutes), so that the legal advice is not provided within the context of the non-privileged executive, commercial and administrative functions of the in-house counsel Legal Director. It should also be borne in mind that the right of privilege between in-house counsel and the company is not recognised in many jurisdictions, including the majority of EU countries.

In-House Counsel taking on or aspiring to the role of Legal Director will need to carefully balance their duties and activities with the contrasting pressures which apply to all directors, ensuring that they maintain their independence whilst offering a positive contribution to the strategic goals of the company.