PART 1: Section 172 of the Companies Act 2006 - A critical examination
Would a failure to pursue lawful tax planning strategies that would ordinarily lead to a significant increase in shareholder funds expose a director to liability for breach of duty under section 172 of the Companies Act 2006?
Section 172 of the Companies Act 2006 constitutes one of the most controversial andnotably debated provisions in the history of company law, which has attracted alot of criticisms and contradicting ideas as it concerns its substance. The importance of the specific section is evidenced by its close correlation with central issues of corporate governance and management, as well as with modern ethical, environmental and communitarianism concerns. Article continues below...
Section 172 provides clear guidance as to whose interests the directors of a company must protect
Section 172 provides clear guidance as to whose interests the directors of a company must protect, promote and reinforce: “A director of a company must…promote the success of the company for the benefit of its members as a whole”. However,despite this direction towards shareholders’ interests as the core objective ofa company, the section adopts an “Enlightened Shareholder Value (ESV)” approach which tries to engage - to a certain extent - the modern concerns of a society into the corporate governance schemes followed by UK companies. In this way, it is submitted that companies will be able to achieve long-term1benefits for their shareholders and to enhance efficiency, profit and wealth maximisation as well as stability. According to the framework of the section and the way it is formulated, directors must “have regard to” a non-exhaustive list of stakeholder interests only as far as this is in accordance with promoting “the success of the company for the benefit of its members as a whole”. As a result, directors are not obliged to behave “ethically” per se; their paramount objective remains2 to be the shareholders’ interests.
Whether there is breach of duty of a director in failing to pursue lawful tax planning strategies that would ordinarily lead to a significant increase in shareholder funds, depends on many different aspects of s.172. Firstly, it is important to mention that what constitutes “the success of the company” is “one for the directors' good faith judgment”34 in evaluating the company’s objectives. Different companies have different objectives and therefore “success” might take various forms and shapes e.g. increase in dividend rates, increase in share value etc. If a listed company is involved we may assume that one of the main objectives of the company, and most probably one of the core expectations by its shareholders, is the increase in share value. However, this does not mean that a shareholder cannot bring a derivative claim5 on behalf of the company if he feels that the director’s action has caused harm to his interests in another perspective, e.g. as to shareholder funds. Consequently, it is highly likely for a shareholder to bring a derivative action against the director if a lawful tax planning strategy is not pursued.
On the other hand, whether the derivative action will succeed, depends to a great extent on the test of good faith adopted by the section, which seems to follow the old subjective test applied in common law. According to Warren J. in Cobden Investments Ltd v RWM Langport Ltd6, the old provision of good faith is “reflected” in s.172 and therefore the new provision will most likely be interpreted and evaluated in the same way. The explanatory notes to the Companies Act 2006 confirm this outcome. As it concerns the old common law, Lord Greene in Smith & Fawcett 7 expressed the idea that the directors of the company “must exercise their discretion bona fide in what they consider - not what a court may consider - is in the interests of the company”. Also, this is reinforced by Jonathan Parker J. in Regentcrest v Cohen8 where he said that “the question is whether the director honestly believed that his act or omission was in the interests of the company” and “not whether, viewed objectively by the court, the particular act or omission…was in fact in the interests of the company”. In consequence, having a purely subjective test, it was very difficult for the courts to find a breach of duty as long as the director believed in good faith that he was acting in the best interests of the company9; something which seems to re-emerge now with s.172.
Nonetheless, it should be noted that there are two situations in which the courts may take into account objective matters. Firstly, in Charterbridge Corp Ltd v Lloyds Bank Ltd10, Pennycuick J. said that where a director has not thought whether a specific action is in the interests of the company, an objective test should be applied: “whether an intelligent and honest man in the position of a director of the company concerned could…have reasonably believed that the transactions were for the benefit of the company”. Secondly, even if a director submits that he honestly believed he was acting in good faith in the best interests of the company, the court is not obliged to accept his argument if the evidence or other objective elements - e.g. reasonableness - provide otherwise. This implies that the director’s assertion is not immune from criticism and that the court has the power to reject it1112. However, what the director failed to do in our case does not necessarily mean that he was not acting in good faith, since something else, equally important, might have been achieved which justifies his decision. Also, even if harm is caused to the company, this does not constitute complete proof that the director has not acted in good faith13.
In conclusion, it is unlikely for the derivative claim to succeed - despite Keay’s arguments that in many occasions the subjective test was not followed by the courts - since the courts are usually not willing to intervene in this kind of business and financial matters by replacing the director’s opinion with their own. Also, it is often very difficult to prove that the state of mind of the director was different from that which he asserts it was.
1 Company Law Review Steering Group, “Modern Company Law for a Competitive Economy: Developing the Framework” (DTI, London, 2000), para.2.22.
2 Nourse J. in Brady v Brady (1987) 3 B.C.C 535 at : “Where a company is both going and solvent, first and foremost come the shareholders”.
3 Keay, “Good faith and directors' duty to promote the success of their company” Comp. Law. 2011, 32(5), 138-143, p.3.
4 Explanatory Notes to the Companies Act 2006 at para.327.