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:
exposure to liabilities arising from legal action against directors by third parties. The sharp rise in the number of class actions by groups of shareholders in the US has made this a particular concern for directors of British companies with a US listing;
the cost of lengthy Court proceedings. Companies are currently permitted to indemnify a director against the cost of defending legal proceedings, but only when judgment has been given in the director’s favour or he has been acquitted.
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:
they permit, but do not require, companies to indemnify directors in respect of proceedings brought by third parties and applications for relief from liability (covering both legal costs and the financial costs of any adverse judgment except criminal penalties, penalties imposed by regulatory bodies such as the Financial Services Authority and the legal costs of unsuccessful criminal defences or applications for relief);
they permit, but do not require, companies to pay directors’ costs of defence proceedings as they are incurred, even if the action is brought by the company itself or is a derivative action. The director would still be liable to pay damages and to repay his defence costs to the company if his defence were unsuccessful.
Section 19 - Relaxation of prohibition on provisions protecting directors etc. from liability
107.Section 19 does two things:
it inserts into the Companies Act 1985 three new sections - 309A, 309B and 309C - which replace the previous provisions on directors’ liability (but not auditors’ liability) in section 310 of that Act;
it disapplies section 310 from directors and other officers.
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:
a company is prohibited from exempting a director from, or indemnifying him against, any liability “in connection with any negligence, default, breach of duty or breach of trust by him in relation to the company”;
a company is permitted to purchase and maintain insurance against any such liability.
109.There are however some important changes from the previous form of section 310 of the Companies Act 1985. New section 309A:
does not extend to liabilities of officers other than directors. It therefore permits companies to indemnify officers such as the company secretary;
does not retain the words “by virtue of any rule of law”, which are usually taken to refer to a rule of non-statutory law. As a result, the new provisions on directors’ liability are not limited to non-statutory liabilities;
prohibits indemnification of a director by an associated company as well as by his own company. “Associated company” is defined under new section 309A(6) as, in effect, a company in the same group. The prohibition on indemnification by an “associated company” is intended to prevent parent companies and subsidiaries from assuming liabilities in circumstances where the company itself would not be permitted to assume such liabilities. The intention is that the order commencing section 19 will provide that contracts which were permitted under former section 310 but are prohibited under new sections 309A and 309B will remain effective only if they were made before Royal Assent on 28 October 2004;
permits indemnification by the company in respect of proceedings brought by third parties (such as class actions in the US) and applications for relief from liability. New section 309A(4) explains that the prohibition on indemnification does not apply to a “qualifying third party indemnity provision” (“QTPIP”). This is explained further in new section 309B.
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:
in defending any criminal proceedings in which he is convicted;
in defending any civil proceedings brought by the company, or an associated company, in which judgment is given against him;
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:
if a QTPIP is in force for the benefit of one or more directors or was in force during the previous year, this must be disclosed by the company in the directors’ report (and where the director is of one company but the QTPIP is provided by an associated company, in the directors' reports of both companies). Companies which choose not to indemnify directors will not have to make any disclosure;
it applies section 318 of the Companies Act 1985 (under which directors’ service contracts must be open to inspection by shareholders) so QTPIPs must be available for inspection by shareholders. This will permit shareholders to look at an indemnity provision in detail.
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:
repays any loan; or
discharges any other liability to the company
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).