Trouble ahead?

It is a fact of business life that a director or other officer of any type of company may face substantial personal liability for the mistakes that he may make while carrying out the duties of the office. Whatever degree of care is exercised by a generally competent, conscientious and honest company manager, mistakes can and will happen. And, when they do, they may have a serious effect on the wellbeing of the company, or on anyone with whom it has a business relationship. The company’s shareholders, employees, customers or suppliers - or anyone else who is entitled to rely on it being managed properly and effectively - are unlikely to ignore their right to obtain redress when they suffer a serious loss.

In recent years, the law has imposed new, onerous duties on the director. Additional areas of liability have been established, and the standard against which a director’s conduct is measured has been progressively raised.

No director is immune - all are subject to the same law and the same standards, whatever their perceived status or particular management role. It is no longer realistic to think that liability can be avoided by having non-executive status, or by keeping a low profile. Accountability is the watchword. The director must not only demonstrate what has been done but also that it has been done properly.

Whoever may be the enemy at the gate, their arrows will be consistently sharp and lethal. When the enemy is numerous and powerful, as is the case with the shareholders of a major public corporation, the chance of finding a number of dedicated marksmen amongst them is correspondingly high.

What is likely to change?
In July 2001, the UK Company Law Review steering group provided a 525-page report outlining its wide-ranging proposals for a new ‘… inclusive, open and flexible regime for company governance’, which will have an impact on every company and its directors. The probability is that most of these proposals will become law within the life of the present government in accordance with its stated intentions of achieving reform in this area.

It is an intention of the proposed reforms that directors’ duties should be codified much more explicitly than hitherto. While this will undoubtedly enlarge the burden of compliance, the imposition of specific obligations should provide ‘… clear, accessible and authoritative guidance for directors on which they may safely rely on the basis that it will bind the courts and thus be consistently applied …’, which must be a welcome change. However, some of the intended duties are expressed in general terms, such as that ‘to promote the success of the company for the benefit of its members as a whole’, taking into account ‘in good faith ... all the material factors that it is practicable in the circumstances for him to identify’. This is necessarily a subjective process that will always be open to critical review.

Until now, directors have rarely been expected to exercise some particular skill or knowledge that they did not, as a matter of fact, possess. They would not normally be judged by reference to a universal and objective standard. The most obvious exception - and an important one - has been the obligation to recognise and react properly to impending insolvency. If the director failed to meet this essentially objective standard and his company went into liquidation, he would be likely to face personal liability for the loss to creditors caused by such ‘wrongful trading’. The new proposals require the director to ‘exercise the care, skill and diligence’ that would be appropriate to someone in his position, as well as whatever additional knowledge, skill and experience he actually has.

Unsurprisingly, much is made of the director’s obligation to be transparently honest and to avoid conflicts of interest with the company. In simple terms, he cannot benefit directly or indirectly from any action taken by him as a director, or through his connection with the company, unless this action is known to the company, is not contrary to its constitution and is formally approved. Here again, while the sentiments are clear and unobjectionable, there is likely to be practical difficulty in identifying and responding correctly to every potential benefit.

Operating and financial review
Central to the proposed company law reform is the new concept of the operating and financial review (OFR). This is intended to provide ‘a review of the business, its performance, plans and prospects’, and thus to go further than the essentially historic and largely quantitative information revealed by the traditional annual report and accounts. An OFR will be required of a ‘large’ public company (or of a private company some ten times larger than such a large public company), to be prepared by the directors (in accordance with standards and obligations to be announced) and subject to the statutory audit process.

Again there is uncertainty. There will be provisions to exempt commercially sensitive disclosures but to sanction frank and open reporting. The fate of the director who, in the harsh light of hindsight, has said too little or too much is not yet clear.

Who will be punished?
Present company law does not permit directors’ wrongdoing to be readily categorised, as civil or criminal. The reform proposals include measures to define the offence and its consequences more clearly, and also, in the case of criminal offences, to identify more exactly those who should be the subject of prosecution.

It is suggested that, for most purposes, action should be taken against all who ‘… authorised, actively participated in, knowingly permitted, or knowingly failed to take reasonable steps to avoid, the default’. It is probable that the time-honoured definition of an ‘officer’ will be amended to provide better guidance on who falls within this wide group. This would leave the ordinary ‘manager’ as a person who is merely the delegate of the officer and thus less likely to be put into the dock.

Will insurance address these problems? The short answer has to be ‘yes’. Directors and officers (D&O) liability insurance is readily available and is intended to meet the personal financial liability of any director or officer within the insured company or group. If a person is shown to have been acting as a director or officer and their act was wrongful and caused loss, the resultant liability should be covered. The widening of a director’s liability (under a new Companies Act or otherwise) or the emergence of further individuals who may be treated as ‘officers’ for the purpose should not threaten the cover.

It is important that D&O liability insurance is in place. But no insurance will prevent loss. However wide the indemnity to a third party, it cannot compensate for all the internal cost, disruption and stress. The identification and control of risk and the mitigation of losses that arise are just as important as buying insurance.
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Nick Stanbury is an insurance consultant and writer, Tel: 01892 687877,
Email nickstanbury@freenet.co.uk

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