Should UK Company Law adopt the Business Judgment Rule with an Enhanced Duty of Good Faith?

Should UK Company Law adopt the Business Judgment Rule with an Enhanced Duty of Good Faith?

Reforming Director Liability in UK Company Law

1.0 Introduction:

1.1 Statement of Problem:

Director liability is of especial concern within company law because there has to be the correct balance between lifting the corporate veil and holding the director who has failed in his/her duties to account[1]. The Companies Act 2006 (CA 2006) has formulated a number of directors’ duties that are based upon the common law; however, there has been enhancement of this framework, which has given rise to the new enhanced shareholder value (ESV) model[2]. The introduction of the ESV model is integrally linked to an attempt to increase the responsibility of directors, whilst retaining the internal management model[3]. The system did not go as far as to introduce a statutory corporate governance model, which is the route that the USA went through the Sarbannes Oxley Act 2002 (SOX 2002). A potential problem that arises in the UK model is that it has not gone far enough to enforce directors’ duties. A better approach may have been to introduce an enhanced good faith obligation (as opposed to the weak reference in the CA 2006) and then provide the American-Style business judgment rule defence. The purpose of this research is to examine directors’ duties under the CA 2006, in order to ascertain whether they are fairly holding the director to account. The introduction of the business judgment rule is giving the director an additional defence but this defence is only appropriate when the directors’ duties have been developed to ensure that there is a high level of liability present[4]. MacMillan identifies that:

“The business judgment rule ensures that decisions made by directors in good faith are protected even though, in retrospect, the decisions prove to be unsound or erroneous. It provides a deference to prevent courts from second-guessing business decisions that were made in good faith”[5].

There is a link to the concept of good faith is present within English law under the CA 2006’s director’s duties, although there is the fundamental problem that arises in the fact there has been a failure to develop these principles into an effective model of ESV[6]. The current model does not hold the director to account sufficiently, although in abstract the CA 2006 could[7]. The next issue that one has to be consider is how the courts need to interpret director’s duties, in order to increase liability because this was the purpose of the CA 2006[8]. This would need to be coupled with the business judgment defence because there may be instances of a good faith decision that turns out to be a breach of director’s duties[9]. Thus, the defence applies to prevent an injustice[10].

This research argues that a better approach to achieving the ESV envisaged by the CA 2006 is to increase the threshold for escaping liability for breach of director’s duties (i.e. enhancing the good faith application) and then applying the business judgment defence. This paper will examine the nature of director’s duties under the CA 2006, the effect of the English common law and then compare it to the approach taken in the American common law where good faith and the business judgment rule operates.

1.2 Aim and Objectives:

The aim of this research is to evaluate whether American-Style enhanced director’s duties based upon good faith coupled with the business judgment rule should be implemented into UK company law. To meet this aim, this research will:

  • Examine the nature of company law within the Anglo-common law system;
  • Examine the nature of directors’ duties within English law, considering both the common law and new statutory system under the CA 2006;
  • Examine directors’ duties in the American common law and the operation of the business judgment rule;
  • Analyse whether American style directors’ duties and the business judgment rule should be implemented into UK company law.

1.3 Methodology:

This research will undertake a comparative case law study of English and American approaches to the application of directors’ duties. The purpose of the comparative study is to ascertain whether it is possible to implement the American model in the UK[11], whilst bearing in mind whether the American model is in fact an improvement on the current approach within the CA 2006. The American model provides a good case study country because its roots are in the English common law, which means that the same basic legal culture is present that enables the UK model to lend from the American model (and vice versa)[12]. The fundamentals to validate a comparative legal approach is present. Although a case law review is at the centre of this comparative study, it will not be focusing upon a purely black letter law approach[13]. Instead a purposive approach has to take place[14], especially when the CA 2006 does enhance directors’ duties but the case law does not necessarily reflect this. Therefore, a comprehensive and purposive application of the law will take place, in order to determine whether there has to be further reform of directors’ duties and the implementation of the business judgment rule in the UK.

1.4 Chapter Synopsis:

This research will consist of four chapters, which are as follows:

Chapter 2.0: This chapter will examine the nature of company law within the Anglo-common law system, which underpins both English and American model. The Anglo-common law model of corporate governance relies upon the indoor management rule, which focuses on the autonomy of the company contract. The divergences of the US and UK approaches will be briefly touched upon.

Chapter 3.0: This chapter will examine directors’ duties within the CA 2006 and the common law development. The purpose of this chapter is to explore the traditional approach to directors’ duties and then engage with the ESV model that the CA 2006 duties are meant to embrace. Two questions will be raised, which are: (i) has the ESV model been achieved; and (ii) does there have to be further enhancement of directors’ duties.

Chapter 4.0: This chapter will explore American common law directors’ duties and compare them to the English approach, as identified in Chapter 3.0. The discussion will focus on the different approaches to good faith within the context of directors’ duties, in order to highlight how the American common law provides a more enhanced obligation. Then it applies the business judgment rule to soften the effect of the enhanced duties. Thus, this chapter will conclude by considering whether the American approach to directors’ duties with the business judgment rule should be implemented into UK company law.

Chapter 5.0: This chapter will conclude with a concise summary of findings and recommendations that answer the question whether there should be a good faith enhancement of directors’ duties and the introduction of the business judgment rule in the CA 2006.

2.0 The Anglo-Common Law Roots of Corporate Governance The Indoor Management Rule:

2.1 The Internal Management Rule An Overview:

The indoor management rule is at the centre of the English common law model where the primary concern is that the company is governed by itself with little intervention by the courts/legal framework[15]. This means that any legal framework has to be based upon the general premise of supporting the company contract, although there is a valid concept of promoting sustainability in maintaining the company within a framework of national standards[16]. Kraakman et al identify that within the Anglo-common law model, “the primary corporate governance issue is considered to be ameliorating managerial agency costs rather than limiting self-dealing by major shareholders”[17]. This means that the primary concern of company law is to promote self-governance and policing by the shareholder body by ensuring that minimum standards of corporate governance are met. The exact implementation of this self-dealing varies because English law retains the voluntary code[18], whilst the USA applies a legislative approach under the Sarbannes Oxley Act 2002 (SOX) and stakeholder legislation[19]. This research is not going into the fine difference between the legislative and voluntary responses to corporate governance. The main principle that has to be borne in mind is that corporate governance is based upon internal management where the law supports the minimum standards that are owed to the company.

2.2 The Internal Manager The Director:

The director is the internal manager of the company who is governed by the company contract (Articles of Association and any other constitutional agreement) and decisions of the voting body (i.e. shareholders)[20]. This integrative model stems from the theory of Adam Smith, which provides that:

“The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own… Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”[21].

The general premise of the Smithian model is that a self-interested person is the best person to be involved in the policing and managing of the company[22]. This means that the shareholder manager is the most appropriate party to promote the best interests of the company[23], because if there is mismanagement there will be an economic effect on the company’s bottom line[24]. This has proven not to be entirely the case of the most modern version of the Cadbury Code in the UK (i.e. the Corporate Governance Code 2012 (2012 Code)), which retains the comply and explain approach whilst introducing a number of minimum expectations that should be followed by directors to have a sustainably managed company.

2.3 The Indoor Management Rule, Corporate Governance Codes and Directors’ Duties:

The 2012 Code provides that the “comply or explain” approach is the trademark of corporate governance in the UK. It has been in operation since the Code’s beginnings and is the foundation of the Code’s flexibility”[25]. This means that the flexibility of the model will retain the internal management model but the 2012 Code provides best practice[26]. The SOX application of the USA applies a similar model but it is enshrined in a statutory duty as opposed a code of best practice. The fundamental common law principle of internal management is identified in the case of Shaw & Sons v Shaw[27]where the management of the company is undertaken by the directors appointed in the company constitution, which is then policed by the shareholders through voting rights. Thus, for this model to operate effectively it is necessary that there is effective and proactive policing by the shareholder body, which is less prevalent due to the nature of large companies becoming dispersed with institutional investors becoming representative of mass shareholder units[28]. The result of this is that shareholder governance is becoming more of a myth because the individual shareholder may not effectively exercise their rights[29], which enables the potential for abuse by directors and the majority because the opposing voice may not be heard[30] or there is such a dispersion that there is a lack of knowledge of wrongdoing because there is not a direct check and balance as seen the Enron scandal[31]. Thus, the development of prudent legal principles, in order to ensure that there is an effective policing model in place within the context of the internal management rule.

The CA 2006 and SOX 2002 are examples of implementing legislation to bolster director liability within international law by adding additional tools to counter the dispersing of shareholder power. Friedman argues that:

“There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”[32].

The implication is that the director has a broad latitude in his/her management of the company, as long as he is acting within the scope of the company’s constitution and is promoting the success of the company[33]. The main problem is that without an affective check and balance through shareholder policing then the internal management model can fail[34]. Thus, the introduction of corporate governance codes (or laws in the USA) were implemented to raise standards.

2.4 The 2012 Code, Internal Management The Need for Further Implementation:

The Cadbury Code identified that “corporate governance cannot be achieved by structures and rules alone. They… encourage and support good governance, but what counts are the ways in which they are put to use”[35], as long as coupled with responsible directors. The common law was identified as being insufficient, which resulted in the evolution of the Cadbury Code to the 2012 Code and the implementation of enhanced directors’ duties under the CA 2006. The 2012 Code provides that there has to be promotion of five core requirements for sustainability, which are: leadership, effectiveness, accountability, remuneration and relations with shareholders[36]. The lynchpin of sustainable company management are the application of directors’ duties that promote responsibility. The 2012 Code supports this principle but identifies additional principles that directors and companies should follow to promote the success of the company.

Principle A1 of the 2012 Code states:

“Every company should be headed by an effective board which is collectively responsible for the long-term success of the company”[37].

The long-term success of the company requires the directors to consider the role of shareholders and other parties that are essential to the effective management of the company[38]. This means it builds upon the CA 2006 reforms, which emanates from the Law Commission’s Company Law Review in 2000, which provided that success requires “proper balanced view of the short and long term; the need to sustain effective ongoing relationships with employees, customers, suppliers and others”[39]. The directors’ duties in the CA 2006 enshrines this principle through extending the application of tem where company success includes more normative concepts, such as reputation as opposed to merely the bottom line. Nonetheless, the traditional principles of company success and the bottom line has been retained within the case law, even after the implementation of the CA 2006[40]. The inference is that it is necessary to heighten these directors’ duties further, which is what is being suggested within this research whilst adding the business judgment rule.

The UK has adopted a mixed statutory and voluntary model, in order to promote good company governance. For example, it was recognised that the traditional shareholder-director relationship has changed, which means that there has to be added safeguards. One such example is Principle A4 of the 2012 Code, which provides that “non-executive directors should constructively challenge and help develop proposals on strategy”[41]. This means that non-interested directors has been introduced to provide an objective monitor. This monitor can help to achieve Principle E4 of the 2012 Code, which identifies that:

“There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place”[42].

This dialogue is essential to promote shareholder policing, which is at the centre of the internal management model. The fundamental problem is that this model may not have the correct balance between the statutory and voluntary elements of a modern internal management model. The ESV model that the CA 2006 may have the potential of achieving this aim, but there has to be examination of the application of these duties to determine whether further reform is required. This research is going to engage with directors’ duties under English law and then move on to the American model.

3.0 Directors’ Duties under the CA 2006 and the English Common Law:

3.1 The Basis of Director’s Duties:

Directors’ duties are fundamental to the indoor management rule because they are the check and balance to the power that the director has. The power of the director can be linked to the majority or certain elements of the shareholder body to create self-interested allegiances that may result in oppression of the minority and undermine the sustainability of the company[43]. This means that the role of directors’ duties are important to ensure that such actions do not take place. This means that the court should have sufficient direction to uphold directors’ duties. If this is lacking then there will not be a balance between internal management and prudent legislation that is capable of providing the sufficient safeguards that are capable of preventing abuse of director power. Wan argues that:

“The court should scrutinise the decision-making process of the board to ensure that the board considers the stakeholders’ interests and that the board acts fairly in considering the long-term and short-term shareholders’ interests”[44].

The fundamental problem that arises is that the internal management model relies upon minimal intervention by the law, which means that the balance between intervention and internal management is paramount. The basis of the English and American directors’ duties have the same foundations, which is identified by Eisenberg as a “standard of “care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances”[45]. This standard of care is “both subjective and objective. The director or officer must subjectively believe that his conduct is in the best interests of the corporation, and that belief must be objectively reasonable”[46]. This means that if the prudent person would not act in a similar manner then it is unreasonable and there is a breach of directors’ duties if the intention is associated with either a willful or reckless act[47]. The CA 2006 has attempted to find this balance through the ESV model; nevertheless, the problem is that this standard may not have been met due to the courts failing to apply a purposive approach to the enhanced directors’ duties.

3.2 Who is the Director?

If the internal management model is to be effective then it is necessary to implement legislation that creates an effective check on the power of directors. The ESV model of the CA 2006 has taken this aboard and extended the definition of a director. There are two potential director groups, which are: (i) those individuals that are named in the company’s constitution; and (ii) individuals that have the control or power to influence the management of the company (i.e. a de facto/shadow director). The first group is linked to the constitutional framework under s. 33 CA 2006 and confirmed in s. 250 CA 2006. The second group has been recognised in s. 251 CA 2006, which provides “in the Companies Acts “shadow director”, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act”[48]. The statutory recognition of shadow/de facto directors is an important development because it means that there is an extension of the statutory directors’ duties to these individuals, which confirms the common law principle that a controlling shareholder that influences the management of the company will be treated as a director[49]. A shadow director will be identified either through direct or implied used of power[50]. Power can be held by a shareholder where there is a history of deference to the individual that is maintained[51]. The primary question that is asked is whether there is a person outside of the board that has equal or more power than the directors named in the company constitution[52]. The flexible principles that surround who is a director illustrates that the courts will take a purposive approach to identify who has controlling power in the company, even if s/he is not named in the company constitution. The implication is that the myth of the common law merely respecting the company constitution is not strictly true, which indicate that there are ways to challenge the sanctity of the company contract when it is reasonable to do so.

3.3 Directors’ Duties An Evolution:

The fundamental principle is that the director has to act reasonably within the powers provided for in the constitution, in order to promote the best interests of the company[53]. There will not be liability for a bad decision, as long as the director has acted in a manner where it can be reasonably shown that his/her actions were grounded on promoting the best interests of the company[54]. The fundamental problem is to ascertain what is in the “best interests” of the company (i.e. should it be based upon the bottom line or is there a need to consider a broader set of interests[55]). The traditional interpretation has been linked to the bottom line and following the direction of the majority[56]. The problem with this application is that it can result in the marginalisation of the minority and the sustainability of the company can be sacrificed for the bottom line[57]. The introduction of the CA 2006 was to clarify directors’ duties, in order to promote sustainability within the management of the company[58]. The following section is going to examine these duties and how they emanate out of the existing common law.

Section 170 provides that the existing directors’ duties are not to replace the common law; rather there is meant to be enhancement of the common law through codification. As s. 170(3) CA 2006 provides:

“The general duties are based on certain common law rules and equitable principles as they apply in relation to directors and have effect in place of those rules and principles as regards the duties owed to a company by a director”.

This means that the common law remains the source of interpreting the directors’ duties set out in ss. 171 to 177 CA 2006, which means that there may be little effect of the ESV model if the common law is not approached with purposive interpretation by the courts[59]. The primacy of the deference to the company constitution and consequently the majority rule principle within the common law is retained in s. 171 CA 2006. Section 171 CA 2006 provides that a director must: “(a) within the powers that have been given through the company’s constitution; and (b) exercise these powers within the limits prescribed by the constitution”[60]. This requirement is necessary to the internal management rule; however, the problem that arises is that without greater direction whether there should be an enhanced examination of the sustainability of the company then the enhancement of directors’ duties has not occurred.

Probably one of the most important sections on directors’ duties is s. 172 CA 2006 because it provides that the director “must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole”[61]. The use of this terminology could be broadly interpreted. Nonetheless, the fundamental problem that occurs is the terminology seems to be retaining the highly traditionalist approach set out in the common law. The traditional standard that is owed by the directors’ duties is set out in the seminal case of Aberdeen Railway Co v Blaikie Brothers[62], which held that:

“A corporate body can only act by agents, and it is of course the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting”[63].

The fact that s. 172 CA 2006 starts with the traditionalist internal management framework does seem to support the critics of the codification of directors’ duties for failing to meet the ESV that was envisaged[64]. This seems to be confirmed in Re West Coast Capital (LIOS) Ltd[65] and Cobden Investments Ltd v RWM Langport Ltd[66] where the traditionalist view set out in Aberdeen Railway Co v Blaikie Brothers was maintained. Consequently, there seems to have been little difference in the interpretation of directors’ duties because the duty to promote the success of the company remains the primary obligation owed. Nevertheless, s. 172 CA 2006 has been enhanced by what factors should be considered by the directors when considering what is in the best interests of the company. These factors include: (i) the examination of the long term effects of a decision[67]; (ii) what is in the interests of the employees[68]; (iii) how to foster relationships with suppliers, customers and other business interests[69]; (iv) to evaluate how a decision by a company will affect the environment and local communities[70]; (v) whether the decision will uphold the reputation of the company, including maintaining industry standards of good corporate governance and social responsibility[71]; and (vi) to ascertain whether the decision will be fair to all members (shareholders) of the company[72]. The application of this section is not expected to be an exhaustive list of duties; rather, it is to identify that there are a broad set of considerations with every decision that the company makes. Nonetheless, it needs to be reiterated that the primary concern is the best interests of the company as identified in Re West Coast Capital (LIOS) Ltd[73] and Cobden Investments Ltd v RWM Langport Ltd[74] that links to the bottom line. Thus, it is unlikely that the other issues that are contained within s. 172 CA 2006 will be treated as the primary interest if it can be shown that the decision is promoting the majority financial interests and the bottom line of the company.

3.4 Directors’ Duties Merely a Reiteration of the Common Law:

The concept of enhancing directors’ duties through the codification of the common law is unlikely to promote more sustainable directors if there is a failure to promote the considerations of s. 172 CA 2006 above and beyond the bottom line[75]. The obligation of the director is to promote the best interest interests of the company by exercising independent judgment utilising the powers given to the director within the company’s constitution[76]. The standard that this owed is set out in s. 174 CA 2006. The preliminary obligation is set out in s. 174(1) CA 2006, which is that “a director of a company must exercise reasonable care, skill and diligence”. This standard represents the obligation linked to promoting the best interests of the company because this level of skill must be used[77]. Section 174(2) CA goes on to clarify what is meant by reasonable care, skill and diligence where it is held that:

“This means the care, skill and diligence that would be exercised by a reasonably diligent person with- (a)the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and (b)the general knowledge, skill and experience that the director has”.

The operation of s. 174(2) CA 2006 identifies that there is both an objective and subjective standard, which makes sense because a legal or financial director should have heightened obligations due to the level of knowledge and skill that s/he has[78]. The common law will allow for the director to delegate his/her duties, as long as it has been done in a reasonable manner[79]. The standard has been set in Re City Equitable Fire Insurance Co. Ltd[80], which has a low threshold to be satisfied. This indicates that as long as the director is generally acting in a reasonable manner with the intention to promote the best interests of the company then there will not be a breach of directors’ duties. Nonetheless, the case law does indicate that each case will be determined on its facts although the standard set in Re City Equitable Fire Insurance Co. Ltd[81] remains the accepted obligation owed by the director[82]. The use of reasonableness as the way to find liability indicates that the business judgment rule could be present within English law but it has to be breached for liability to be found, which means that it will be very difficult to show that there has been a breach of directors’ duties unless the actions of the director is absurd.

The remaining sections further clarify the common law standards seem to apply to the tests set out in ss. 172-174 CA 2006. Section 175 CA 2006 provides that “a director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company”[83] unless authorisation has been given by the board to undertake the disclosed duties[84]. All votes that are taken on authorisation has to take place without that of the interested director[85]. The conflict of interest will be any contract/activity that will be competing with the business purpose of the company and/or reasonable restrictions identified in the company contract because there is a duty of loyalty owed by each director[86]. It is also important to stress that authorisation does not have to be formal; rather it is possible for acceptance of potentially conflicting actions will be allowed as long as appropriately disclosed[87]. The main concern is to show that the director has not acted in a conflictual manner that undermines the best interests of the company[88]. It is the conflict of interest standard that gives rise to the duty not to accept benefits from third parties when related to activities of an individual is acting in his/her capacity as a director[89]. Thus, the duties that have been developed in the CA 2006 are merely a codification and arguably a clarification of common law duties, which potentially will maintain the status quo (as identified in Re West Coast Capital (LIOS) Ltd[90] and Cobden Investments Ltd v RWM Langport Ltd[91]). Arguably there has to be a change in how director’s duties are treated, in order to ensure that they are enhanced. The response could be by making a stringent set of directors’ duties and then applying the reasonable skill and care as a defence (i.e. the business judgement rule).

4.0 Directors’ Duties in the USA and the Business Judgment Rule Should they be Implemented in the UK?

4.1 The Business Judgment Rule and the American Directors’ Duty:

The business judgment rule with heightened obligations to reinforce directors’ duties could be introduced, instead of having to breach this rule to be held liable as in the English model. The basis of directors’ duties in the USA are similar to that as in English law. However, the Dodge v Ford Motor Company[92] espouses this in a duty to protect the interests of the shareholder (i.e. the best interest of the company are the interests of the shareholders). This is a shift from the English model because there is a clear fiduciary obligation owed by the director to the shareholder. The business judgment rule is contained within the common law and in some states has been codified. An example of a codified business judgment rule is in the California Corporations Code § 309(a), which provides that:

“A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances”.

The obligation of the director is identified in the first part of the rule where the director must conform to the prescribed duties[93]. This is then followed by a defence that the director has acted reasonably in the best interests of the company where reasonable inquiry of a prudent person in a similar positon would have acted the same (i.e. it is a reasonable response in a range of reasonable responses)[94]. Thus, it starts from liability for breach of duty and then applies a defence, which means that it is a reverse of English law. Additionally, there is a shareholder focus in American law that is not present in the English common law[95]. This discussion is going to examine the application of the business judgment rule in US cases whilst comparing it to the approach taken in the English common law.

The starting point to understand the business judgment rule is the seminal case of Unocal Corporation v Mesa Petroleum[96], which has been upheld in Revlon Inc v MacAndrews & Forbes Holdings Inc[97]and a series of other cases. Unocal held that the business judgment rule is a defence to the high obligation that directors’ duties impose. As this case held:

“If a defensive measure is to come within the ambit of the business judgment rule, it must be reasonable in relation to the threat posed”[98].

This means that a breach of duty may occur but it was a reasonable response given the nature of the decision or it is thought to be the best approach in the given circumstances. It is important to note that generally the fiduciary duty that the director owes is just to the shareholder[99], unless the legislature has enhanced this duty in a particular state (e.g. the environmental obligations in Oregon[100]). The implication is that there is a dual duty present to promote the best interests of the company and the interests of the shareholders[101], which means that minority as well as majority shareholder interests must be considered. The rationale is that there is a direct claim for the shareholder that has been harmed by the director that has breached his/her duty. Once this breach is shown then the director can defend his/herself through the business judgment rule. Resultantly, there are similarities between the American and English common law; however, the burden of proof is different. The question that this research seeks to answer is whether the American approach should be implemented into the UK, in order to solidify the ESV model that were envisaged by the CA 2006.

4.2 A Case Law Review of the Business Judgment Rule:

This research is going to focus on the Delaware case law because it has the closest roots to the English common law. It is not possible to examine the business judgment rule in the USA as a whole because of the number of different systems. As VantagePoint Venture Partners v. Examen, Inc[102] held only the states “should have the authority to regulate a corporation’s internal affairs-the state of incorporation”[103]. This means that it is easier to undertake a case law review of a state. The links between Delaware and the English common law is the fact that directors’ duties have been developed upon the backbone of Charitable Corp. v. Sutton[104], where directors are described as both agents and trustees of the company and should act with “fidelity and reasonable diligence”[105]. This approach was confirmed in Bodell v. General Gas & Electric Corp[106]. The Bodell approach was confirmed in Cole v. Nat’l Cash Credit Ass’n[107] where it was held that fidelity and reasonable diligence are the “elemental requirements for invoking the Delaware business judgment rule-good faith and a ‘bona fide’ purpose”[108]. This approach was reaffirmed in the 1971 case of Sinclair Oil Corp. v. Levien[109] where the business judgment rule will be valid if for a valid business purpose. This was supported in Aronson v. Lewis where the held that the business judgment rule “is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company[110] . As Stone v. Ritter[111]identifies, the director owes a duty to the shareholders and companies that is based upon the “triad [of] due care, loyalty and good faith”[112]. This triad is similar to the construction of the directors’ duties in the English common law and under the CA 2006. In fact, the Stone Case recognised that the business judgment rule allows for a balance when these duties compete. This seems to be very similar to Shaw & Sons v Shaw[113] where the internal management model requires that the best interests of the company be upheld above all else.

There has been a breach of directors’ duties when the board failed to act on an informed basis[114]. This links to the obligation of due skill and care set in s 174 CA 2006, which means that there are the similarities to import the American model into the UK. This can also be seen in Guth v. Loft[115] where it was held that “corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests”[116]. This means that the conflict of interest obligation in the US model is similar to s. 175 CA 2006, although it is identified in a strictly prohibited language. Thus, there is a breach for acting this way and then the director can defend his/herself by showing it is permitted. The enhancement of directors’ duties under the US model lies upon the fact that directors are fiduciaries that have a “quasi-trustee and agency relationship” that is owed to the company and its shareholders[117]. Therefore, the nature of the duty is heightened due to the direct trustee relationship.

In fact, the business judgment rule cannot be used when there is a potential conflict of interest, as Aronson identifies this rule “can only be claimed by disinterested directors whose conduct otherwise meets the tests of business judgment”[118]. The impact of tis is that the directors that has been identified to be in breach of their duties have to show that they are not on either side of the transaction or “expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders general”[119]. The presence of such an interest will mean that the business judgment rule will not be applied[120]. Therefore, the benefit of this approach is that conflict of interest is more strictly applied because it does not benefit from the defence of the business judgment rule. Conversely, the obligation that is owed by the director in the English common law merely requires the act to be reasonable and promotes the company’s best interests.

The concept of good faith within US case law is also heightened. For example in re Walt Disney Co. Derivative Litigation[121] held that due care “may overlap with the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct”[122]. The implication is that good faith is not part of the obligation of skill and care, which seems to be the approach that has taken under English law because good faith is not a standalone ground. Consequently, it may be that the lynchpin of heightened directors; duties in the US model relies upon a standalone obligation to act in good faith, which means that it is necessary to examine what is meant by good faith in the ambit of directors’ duties.

The Delaware Supreme Court in Stone v. Ritter[123] identified that “good faith may be described colloquially as part of a “triad” of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty”[124]. However, it goes on to identify that this colloquial approach is not in fact true because a “director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest”[125]. This means that the good faith principle has to be a standalone obligation. The colloquial description is clearly the obligation that is owed in the English common law; whereas the US duty is heightened. The English common law approach is identified in Charitable Corp. v. Sutton where it is held that “it is by no means just in a judge, after bad consequences have arisen from [any exercise of] power, to say [the director] foresaw at the time what [would] happen, and therefore were guilty of a breach of trust”[126]. The rationale is that a standalone obligation of good faith cannot be applied in hindsight to hold the director to account because a seemingly good decision became a bad one. All that needs to be shown for a breach not to be identified is that the decision was not made in bad faith. This may seem to be fair, but it fails to engage the potential responsibilities of the director (especially when there is a potential harm to a certain sector of the company).

The case of Stone v Ritter illustrates that there is a distinctly different approach that is applied in the US model. In this case the Delaware Supreme Court held that:

“In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’ and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome”[127].

The engagement with the different factors that could arise from a decision has to be examined in full, which means that there is an obligation to ensure that a reasonable decision has been made. Consequently, there is a higher threshold imposed upon identifying what is expected to be a reasonable business decision as opposed to the broad range of reasonable responses in the English common law. This distinction lies in the fact that the director owes his/her duty not only to the company in general but also the individual shareholders. Therefore, there are sound grounds to apply the US style directors’ duties (especially the good faith duty that is sound alone) and then apply the business judgement rule.

5.0 Conclusion: Should the Business Judgment be Implemented in the UK?

The Delaware Supreme Court in Aronson v. Lewis identified that the operation of the business judgement rule is based upon the “presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company”[128]. This means that a business decision may harm part of the shareholder body but was necessary to promote the welfare of the company and the majority. The application of this approach seems very similar to that of the English common law, although it is the point to defend a breach not the threshold to prove a breach. The obligation to act in good faith to promote the interests of the business are clearly identified in the English common law[129], although this obligation does not extend to the individual shareholder (except through an enhanced application of s. 172 CA 2006). The operation of the good faith principle is enhanced in the UK when there is a conflict of interest because it implies that the intention is personal and not to promote the interests of the company[130]. Nonetheless, this still does not have the effect of increasing the liability of directors. There are attempts in the common law to recognise an enhanced duty on non-executive directors because they are acting without self-interest. The Australian courts in Australian Securities and Investments Commission v Healey[131] identified that there is an obligation on the non-executive director “to take a diligent and intelligent interest in the information available to him or her, to understand that information, and apply an enquiring mind to the responsibilities placed upon him or her”[132]. The rationale of this approach is that there is a special relationship of trust because the non-executive director has no interest in the company but to promote the company’s interests. This approach does not satisfy the formation of effective directors’ duties. Rather, it is necessary to create a heightened fiduciary duty in the UK for directors in general

The standalone duty of good faith should be developed in the UK because the fact that a breach is difficult to prove indicates that there will not be enhancement of shareholder value. In fact, the case of R. (on the application of People & Planet) v HM Treasury[133] illustrates the problem with failing to provide a standalone duty of good faith. In this case, the applicants wanted to get the government to enforce the RBS’ own policy that it promoted it held in combating climate change and promoting human rights on the board of RBS. The government has this power because of part of RBS becoming public. However, the court held that it did not have the power to enforce this obligation because it would be contrary to the board who are acting in their power. This argument may be true, but the company is acting in bad faith because it is promoting a policy to its shareholders and customers and not following it through, which is misrepresentation. This act would be deemed as a breach of good faith in the USA because it is unreasonable to lie. Therefore, it seems that it is necessary to implement the US’ heightened directors’ duties but to provide the business judgment rule to prevent liability when there has been a truly reasonable set of actions. The benefit of this approach is that it will create a more onerous duty of care, which is necessary to ensure that there is truly an ESV model in the UK.

The development of an ESV model was envisaged when the CA 2006’s directors’ duties were implemented. The fundamental problem that arose is that this has not been the case because the threshold to show that there is a breach is set to high. The main problem in the English model is that the business judgment defence is not a defence; rather, it is the standard to prove that there has not been a breach of directors’ duties. Consequently, the English model’s liability for breach of duty is too easy to avoid, which is supported by the fact that there is no standalone duty of good faith. It is argued that the US model should be implemented where there is a standalone duty of good faith and breach of duty can be proven with a lower threshold. However, the business judgment rule operates as a defence when there has been a breach of duty, but the action is in good faith and was considered to be reasonable in the given circumstances. These changes will create a system where there is ESV, but in order for the US model to be effectively implemented in the UK it is necessary that a standalone duty of good faith is accepted. This will be the greatest obstacle to the proposed reform. Nonetheless, it is necessary to create the ESV model that was envisaged in the CA 2006’s directors’ duty reform.


[1] Parker, H. “Directors’ Duties Under the Companies Act 2006: Clarity or Confusion?” (2013) 13 Journal of Corporate Legal Studies 1, 5

[2] Keay, A The Enlightened Shareholder Value Principle and Corporate Governance (Routledge, 2012), 230

[3] Ibid, 230

[4] MacMillan, L “The Business Judgment Rule as an Immunity Doctrine” (2013) William and Mary Business Law Review 4(521), 524

[5] Ibid, 526-527

[6] Keay (n2), 230

[7] Ibid, 231

[8] Ibid, 231

[9] MacMillan (n4), 524

[10] Ibid, 524

[11] Zweigert, K and Kotz, H An Introduction to Comparative Law (trans Tony Weir) (3rd Edition, OUP, 1988), 40

[12] Nelken, D “Culture, Legal” in Clark, DS. (ed.) Encyclopedia of Law and Society: American and Global Perspective (Sage, 2007), 369

[13] Hill, DK “Law School, Legal Education and the Black Letter Law Student” (1986) 12 T Marshall Law Review 557, 452

[14] Zweigert, & Kotz (n11), 40

[15] .Armour, J, B.S. Black, B.R .Cheffins and R. Nolan, ‘Private Enforcement of Corporate Law: An Empirical Comparison of the UK and the US’ (2009) 6 Journal of Empirical Legal Studies 687

[16] Parker, H. “Directors’ Duties Under the Companies Act 2006: Clarity or Confusion?” (2013) 13 Journal of Corporate Legal Studies 1, 5

[17] Armour (n4) 690

[18] .Armour, ‘Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment’; in J Armour and J Payne (eds), Rationality in Company Law (Oxford: Hart Publishing 2009) copy available at: Click here to read the full article accessed June 25, 2015, 5

[19] Mallen, C Corporate Governance (3rd Ed, OUP, 2009), 10

[20] French , D, Mayson, S and Ryan, C Mayson Ryan and French on Company Law, (OUP, 2010) 89

[21] Smith, A (1776) The Wealth of Nations (Digireads, 2004) 439

[22] Carrillo, E “Corporate Governance: Shareholders’ Interests and other Stakeholders’ Interests”, (2007) Corporate Ownership and Control 4, 98

[23] Jensen, M. and Meckling, W. “Theory of the firm managerial behaviour, agency costs and ownership structure”, (1976), Journal of Financial Economics, 32(305), 359

[24] Eisenberg, M ‘The divergent standards of conduct and standards of review in corporate law’ (1993) 62 Fordham Law Review. 438, 440

[25] Financial Reporting Council The UK Corporate Governance Code September 2013, 4 (2012 Code)

[26] Stokes, M “Company and Legal Theory” in Twining W Legal Theory and the Common Law (Basil-Blackwell, 1986), 163

[27] Shaw & Sons (Salford) Ltd v Shaw [1935]2 K.B. 113

[28] Bebchuk, LA “The Case for Increasing Shareholder Power” (2005) Harvard Law Review 118(833), 885

[29] Nolan, RC ‘The Continuing Evolution of Shareholder Governance’, (2006) 65 Cambridge Law Journal 92, 93

[30] Moore, MT Corporate Governance in the Shadow of the State (Hart, 2013), 273

[31] Li, Y “The Case Analysis of the Scandal of Enron” (2010) International Journal of Business and Management 5(37), 37

[32] Friedman, M. “The Social Responsibility of Business is to Increase its Profits” (1970)The New York Times Magazine (September 13)

[33] Bloomfield, S Theory and Practice of Corporate Governance: An Integrated Approach (CUP, 2013), 203

[34] La Porta, Rafael & Lopez-de-Silanes, Florencio & Schleifer, Andrei & Vishny, Robert, “Investor Protection and Corporate Governance,” (2001) Working Paper Series rwp01-017, Harvard University, John F. Kennedy School of Government, 15

[35] Cadbury Report of the Committee on the Financial Aspects of Corporate Governance, December 1992, para. 3.13.`

[36] Financial Reporting Council, (n25), 6-7

[37] Ibid, 8

[38] Ibid, 8

[39] Company Law Review, Modern Company Law for a Competitive Economy, Developing the Framework (DTI, 2000), para 2.19

[40] Re West Coast Capital (LIOS) Ltd (2008) CSOH 72; Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch)

[41] Financial Reporting Council, (n25(, 10

[42] Ibid, 24

[43] Wan, WY “Takeovers and Countering Short-termism in Target Boardrooms: Part 1” (2013) Company Lawyer 34(43), 43

[44] Ibid, 68

[45] Eisenberg, M ‘The divergent standards of conduct and standards of review in corporate law’ (1993) 62 Fordham Law Review. 438, 440

[46] ibid, 440

[47] Ibid, 440

[48] S. 251(1) CA 2006

[49] Bushell v Faith [1969] 1 All ER 1002

[50] Secretary of State for Trade and Industry v Devrell [2000] 2 WLR 9070

[51] Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1990] BCC 567

[52] Re Hydrodan (Corby) Ltd [1994] BCC 161

[53] Riley, CA ‘The Director’s Duty of Care and Skill: The Case For an Onerous But Subjective Standard’ (1999) Modern Law Review 697, 697-8

[54] Ibid, 698

[55] Reisberg, A ‘Shadows of the Past and Back to the Future: Part 11 of the UK Companies Act 2006 (in)action’ (2009) 6 European and Company Financial Law Review 219, 221

[56] Ibid, 221

[57] Ibid, 222

[58] Ibid, 222

[59] Ibid, 222

[60] S. 171 CA 2006

[61] S. 172(1) CA 2006

[62] Aberdeen Railway Co v Blaikie Brothers (1854) 1 Macq 461

[63] Ibid 471

[64] Reisberg (n55), 222

[65] Re West Coast Capital (LIOS) Ltd (2008) CSOH 72

[66] Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).

[67] s. 172(1)(a) CA 2006

[68] s. 172(1)(b) CA 2006

[69] s. 172(1)(c) CA 2006

[70] s. 172(1)(d) CA 2006

[71] s. 172(1)(e) CA 2006

[72]s. 172(1)(f) CA 2006

[73] Re West Coast Capital (LIOS) Ltd (2008) CSOH 72

[74] Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).

[75] Reisberg (n55), 222-3

[76] S. 173 CA 2006

[77] Lister v Romford Ice and Cold Storage Co. Ltd [1957] A.C. 555

[78]Keay (n2), 234

[79] Re D’Jan of London Ltd [1994] 1 B.C.L.C. 561, CA; Cohen v Selby [2001] 1 BCLC 176, CA

[80] Re City Equitable Fire Insurance Co. Ltd [1925] Ch. 407

[81] ibid

[82] Equitable Life Assurance Society v Bowley [2004] 1 B.C.L.C. 180; Re Barings plc (No. 5) [2000] 1 B.C.L.C. 523

[83] S. 175(1) CA 2006

[84] S. 175(5) CA 2006

[85] S. 175(6) CA 2006

[86] Item Software (UK) Ltd v. Fassihi [2005] 2 B.C.L.C. 91

[87] Murad v Al-Saraj [2005] EWCA Civ 959; Foster v Bryant [2007] Bus LR 1565

[88] Edwards v Halliwell [1950] 2 All ER 1064

[89] S. 176(1) CA 2006

[90] Re West Coast Capital (LIOS) Ltd (2008) CSOH 72

[91] Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).

[92] Dodge v. Ford Motor Co., 170 N.W. 668 (Michigan Supreme Court, 1919)

[93] Adams, MS “United States: The Director’s Friend: The Business Judgement Rule” Mondaq Sepetember 6, 2012 available at: Click here to read the full article accessed June 27, 2015

[94] Ibid

[95] Simpson, S & Brody, K “The Evolving Role of Special Committees in M&A Transactions: Seeking Business Judgment Rules Protection in the Context of Controlling Shareholder Transactions and Other Corporate Transactions Involving Conflicts of Interest” (2014) Business Lawyer 69(1117), 1120

[96] Unocal Corporation v Mesa Petroleum (1985) 493 A 2d 946 (Delaware Supreme Court).

[97] Revlon Inc v MacAndrews & Forbes Holdings Inc (1986) 506 A 2d 173; See also Paramount Communications Inc v Time Inc (1990) 571 A 2d 1140, Nixon v Blackwell (1993) 626 A 2d 1366, Paramount Communications Inc v QVC Network Inc (1994) 637 A 2d 34, Herald Co v Seawell (1972) 472 F 2d 1081

[98] Unocal Corporation v Mesa Petroleum (1985) 493 A 2d 946 (Delaware Supreme Court), [at pg. 955].

[99] Paulman v. Kritzer, 219 N.E.2d 541, 543 (Illinois Appellate Court, 1966).

[100] Sneirson, J Race to the Left: A Legislator’s Guide to Greening the Corporate Code, (2009) Oregon Law Review, 88,498.

[101][101] Fletcher v. Atex, Inc., 68 F.3d 1451, 1456 (2d Cir. 1995)

[102] VantagePoint Venture Partners v. Examen, Inc., 871 A.2d 1108, 1112 (Del. 2005).

[103] ibid

[104] Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742);

[105] ibid

[106] Bodell v. Gen. Gas & Elec. Corp., 132 A. 442 (Del. Ch. 1926),

[107] Cole v. Nat’l Cash Credit Ass’n, 156 A. 183, 188 (Del. Ch. 1931)

[108] ibid

[109] Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)

[110] Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)

[111] Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)

[112] I bid

[113] Shaw & Sons (Salford) Ltd v Shaw [1935]2 K.B. 113

[114] Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).

[115] Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939)

[116] ibid

[117] Moran v. Household Int’l, Inc.,500 A.2d 1346, 1357 (Del. 1985)

[118] Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)

[119] ibid

[120] ibid

[121] Re Walt Disney Co. Derivative Litig., 906 A.2d 27, 65 (Del. 2006)

[122] ibid

[123] Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)

[124] ibid

[125] ibid

[126] Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742)

[127] Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)

[128] Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)

[129] Mutual Life Insurance Co of New York v. Rank Organisation Ltd [1985] B.C.L.C. 11

[130] Scottish Cooperative Wholesale Society Lttd v Meyer [1959] AC 324; Bhullar v Bhullar [2003] EWCA Civ 424

[131] Australian Securities and Investments Commission v Healey [2011] FCA 717

[132] Ibid at , 20

[133]R (on the application of People & Planet) v HM Treasury [2009] EWHC 3020 (Admin).

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