Explanatory Notes

Companies (Audit, Investigations and Community Enterprise) Act 2004

2004 CHAPTER 27

28 October 2004

Commentary on Sections

Part 1:  Auditors, Accounts, Directors' Liabilities and Investigations

Chapter 3: Directors' liabilities

99.Sections 19 and 20 relax the prohibition on provision made by companies protecting directors and other company officers from liability.  They form part of the Government’s response to its consultation on director and auditor liability of December 2003.

Background
The nature of directors’ potential liabilities

100.Directors’ general duties are owed to the company rather than to individual shareholders.  It therefore falls to the company to take action for breach of duty (including the duty of care, skill and diligence): in practice this usually means the board of directors (in some cases a new board of directors) or the administrator or liquidator.

101.Directors may also have liabilities to third parties e.g. in respect of a class action by a group of shareholders in the US, or criminal or regulatory penalties.

102.The prohibition on companies exempting their officers from, or indemnifying them against, liability in respect of any negligence, default, breach of duty or breach of trust in relation to the company dates back to the 1920s.  It arose because individual company articles were beginning to relieve directors from the consequences of breach of their duties. This meant the shareholders were unable to obtain redress, especially as the courts then took a very relaxed approach to the directors’ duty of care. Parliament therefore changed the law in 1928 so that these exemption clauses ceased to have any effect.  The Companies Act 1989 relaxed the prohibition by providing that companies could purchase liability insurance for directors and pay their legal costs if they were successful in defence of legal proceedings.

The Department’s consultation on directors’ liability

103.The Department of Trade and Industry published a consultative document in December 2003 in response to business concerns that suitably qualified individuals may be deterred from accepting positions as company directors.  The consultation exercise built on the work of the independent Company Law Review and of the subsequent review of the role and effectiveness of non-executive directors undertaken by Sir Derek Higgs.

104.The consultation identified two particular concerns:

105.The consultation provided strong evidence that these issues are affecting the recruitment and behaviour of directors.   Sections 1 9 and 20 have therefore been included in the Act to address these concerns.

Summary

106.The new sections inserted by sections 19 and 20 replace the existing provisions on directors’ liability (but not auditors’ liability) in section 310 of the Companies Act 1985.  Because of this, they begin by setting out the basic prohibition on companies exempting directors from, and indemnifying them against, liability to the company, but they also introduce two important relaxations of the prohibition:

Section 19 - Relaxation of prohibition on provisions protecting directors etc. from liability

107.Section 19 does two things:

108.New section 309A begins by restating the core prohibition on companies exempting directors from, or indemnifying them against, liability.  Many of the key elements are retained from the previous form of section 310 of the 1985 Act.  In particular:

109.There are however some important changes from the previous form of section 310 of the Companies Act 1985.  New section 309A:

110.New section 309B explains that a QTPIP must satisfy three conditions:

Condition A is that the provision does not indemnify the director against a liability to the company or to any associated company;

Condition B is that the provision does not indemnify the director against payment of a criminal fine or a regulatory penalty (such as a fine imposed by the Financial Services Authority);

Condition C is that the provision does not indemnify the director against any liability incurred:

(a)

in defending any criminal proceedings in which he is convicted;

(b)

in defending any civil proceedings brought by the company, or an associated company, in which judgment is given against him;

(c)

in an unsuccessful application for relief from liability under the provisions for relief in the Companies Act.

111.New section 309B(5), 309B(6)  and 309B(7) explain when legal proceedings will be considered to have concluded in respect of Condition C.

112.New section 309C requires the company to make two forms of disclosure about indemnification by the company or an associated company:

113.Section 19 also amends section 310 of the Companies Act 1985 by removing the references to directors and officers of the company.  Section 310 now applies only to auditors, with new sections 309A, 309B and 309C setting out the prohibition and related provisions in respect of directors.  Other officers, such as the company secretary, are no longer covered.

Section 20 - Funding of director’s expenditure on defending proceedings

114.Sections 330-344 of the Companies Act 1985 place restrictions on a company’s power to make loans or quasi-loans to directors, or to enter into certain types of credit transaction with a director.  The prohibition prevents a company from indemnifying a director on an ‘as incurred’ basis even against his legal expenses.

115.Section 20 therefore inserts a new section - section 337A - into these sections of the  1985 Act.    New section 337A provides that a company is not prohibited from funding a director’s expenditure in defending any civil or criminal proceedings provided that the director:

if he is convicted in any criminal proceedings or judgment is given against him in any civil proceedings, or he is unsuccessful in an application for relief from liability under the provisions for relief in the Companies Act.  Under new section 309B, however,  a company may permit a director not to repay a loan if all the circumstances for a QTPIP (see paragraph 110 above) are satisfied (particularly in a case in which judgement is given against him in proceedings brought by a third party).