The Company Law Reform Bill: an overview

On 1 November 2005 the Company Law Reform Bill (the Bill) was finally introduced to the House of Lords, seven years after the review of the existing law began. Some of the detailed provisions of the Bill are still being debated but when it comes into force – which is expected to be in April or October 2007 – it will affect companies of every size. Principally, the Bill aims to:

• simplify the administrative burden on smaller private companies, which make up the vast majority of the corporate population
• facilitate shareholder engagement, particularly in quoted companies
• update and clarify the law in various areas, particularly in relation to directors’ duties.

The principal areas of reform are:

1. Directors and corporate governance
2. General meetings, resolutions and shareholder rights
3. Capital maintenance and transactions benefiting shareholders
4. Auditors and accounts
5. Company administration

Statutory statement of directors’ duties

For the first time, the duties owed by directors to their company will be set out in statute, making them clearer and more accessible than at present. Sections 154-170 of the Bill are intended to codify the duties that have been established in cases to date, although slight changes will be made in relation to conflicts of interest.

Relevance of previous cases

Although the new duties expressed in the Bill will displace those formulated in previous cases, cases on directors’ duties will continue to be relevant for the purpose of determining how those duties should be applied in particular circumstances. However, cases in which a duty was formulated in a different way, especially one that is inconsistent with the statutory statement, are likely to have less authority.

Fiduciary duties

A director must:

• act within his powers under the company’s constitution, and only exercise powers for the purposes for which they are conferred. These reflect the ultra vires rule and the duty to exercise powers for “proper purposes” only and are uncontroversial.
• act in the way he believes, in good faith, is most likely either to promote the success of the company for the benefit of its members or, if the company is not established for the benefit of its members (which means charities and other “not for profit” companies, trade associations, etc), to achieve its purposes.
• exercise independent judgement, and not fetter his discretion except pursuant to an agreement that was considered to be in the best interests of the company when it was entered into.
• avoid conflicts of interest.
• not accept benefits from third parties.
• his interest in any proposed transaction or arrangement.

The director must also exercise reasonable care, skill and diligence. This is explained as the care, skill and diligence that a reasonably diligent person would exercise if they had both the knowledge, skill and experience reasonably expected of a person in the director’s position and also any additional knowledge, skill or experience that that director actually has. This combined objective and subjective test reflects section 214 Insolvency Act 1986, and has been applied in recent cases – i.e. the higher of the knowledge, skill and experience reasonably expected of a director in that position, and the knowledge, skill and experience of that particular director.

Duty to promote the success of the company

As mentioned above, directors will have a duty to 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. The Bill provides that this is interpreted subject to having regard (as far as reasonably practicable) to:

• the likely consequences of any decision in the long term;
• the interests of the company’s employees;
• the need to foster the company’s relationships with customers, suppliers and others;
• the impact of the company’s operations on the community and the environment;
• the desirability of the company maintaining a reputation for high standards of business conduct; and
• the need to act fairly as between members of the company.

The obligation to take account of these statutory factors is said to embody the concept of “enlightened shareholder value”. At first reading, these seem innocuous - even, perhaps, helpful co-ordinates in pinning down the nebulous concept of promoting the success of the company. But these factors may in practice considerably increase the bureaucratic and documentation aspects of decision-making.

In the DTI’s Guidance on key clauses, published alongside the Bill, the Government stresses that the obligation to “have regard to” the statutory factors cannot be discharged merely by paying lip service to them: directors must exercise the same level of skill, care and diligence as they would in carrying out any other function, at least as far as is “practically possible in the circumstances of any particular business decision”. Directors are therefore expected to do all that they reasonably can to take these factors into account: the more significant a decision, the more important it will be to ensure there is a paper trail showing that the board has actively considered how a particular decision will impact the company’s employees, customers, suppliers, the environment and its commercial reputation.

Another concern is that pressure groups will use this as a means to create bad publicity for companies and that, as a result, business will become risk averse because directors will be personally liable to their companies.

Could directors be found liable for failing to have due regard to these factors, or for attaching insufficient weight to them? The formula “have regard (as far as reasonably practicable)” clearly acknowledges that, depending on the circumstances, directors may legitimately decide that other pressures and constraints outweigh any or all of these statutory factors. Judges have normally been reluctant to re-examine commercial judgements of this kind made by directors, but this has not prevented the courts from occasionally attacking decisions where, on the facts they knew or ought to have known, the directors have failed to take into account all relevant factors, or taken irrelevant factors into account, or come to a conclusion that no reasonable director, properly directing himself as to his duties, could have reached.

As long as a director can show that he did actually consider the statutory factors, even if he ultimately decided that they were less important than other factors, he will probably – in the absence of anything patently perverse or irrational - have discharged his duty. In any event, liability will only follow if the company can show that it suffered a loss as a result of the director’s breach of duty.

Changes to rules on conflicts of interest

Where a transaction is proposed between a director and his company, so that the director’s duties to the company may be in conflict with his personal interests, the rules of equity currently require shareholders to approve the transaction. Companies’ articles frequently modify this equitable duty, instead simply requiring directors to disclose their interest to the rest of the board.

Clause 161 of the Bill reflects the current position in section 317 Companies Act 1985 and in the articles of most companies, as it requires an interested director to disclose the nature of his interest to the rest of the board before the transaction is approved. Disclosure need not be made if the interest cannot reasonably be regarded as likely to give rise to a conflict of interest or if the other directors are already aware of the director’s interest. These caveats broadly reflect principles established in related case law.

Existing equitable rules prevent a director from exploiting personally without permission any opportunity that properly belongs to the company, even if the company is not itself in a position to exploit it. Believing this to hinder entrepreneurial and business start-up activity, the Government has included provisions in clause 159 of the Bill that will allow non-conflicted directors to authorise a director to proceed notwithstanding his conflict of interest. Directors of public companies will only be able to authorise such conflicts if the articles allow it.

Transactions between directors and their companies

Various changes will be made to the rules on substantial property transactions between companies and their directors, on loans to directors, payments to directors for loss of office, and on long-term service contracts, principally to make the rules more accessible and consistent, and to remove a number of ambiguities.

For example:

• All companies will be able to make loans to their directors if the loan is approved by shareholders. At present such loans are generally prohibited, subject to various exceptions.
• The rules on quasi-loans and credit transactions, which currently only apply to companies that are public or that are members of a group containing a public company, will be extended to all companies.
• Companies will be able to enter into transactions that would currently fall within section 320 Companies Act 1985 before shareholder approval has been obtained, as long as the transaction is made conditional on such approval.
• Shareholder approval will be required where a company proposes to make a payment to a director in compensation for loss of his employment as a director of the company (not just for loss of his office as a director) which goes beyond his existing contractual entitlement.

The complex rules in existing section 346 Companies Act 1985 determining which persons are “connected” to a director for these purposes will also be re-written and extended to catch a director’s civil partner, a person who lives with the director “as partner in an enduring family relationship”, the director’s parents, and any infant children or step-children of the director’s partner who live with him.

Transactions with third parties: ultra vires

Unless a company’s objects (which will be contained in its articles – see section 5 below) are specifically restricted, they will be deemed to be unrestricted as far as third parties are concerned.

Sections 35-35B Companies Act 1985, which deal with a company’s capacity and the power of directors to bind it, will be replaced with new provisions that do not make any substantive change to the current rules. A third party will continue to be protected if he deals with the company in good faith. Third parties dealing with a company will still have to concern themselves with the question of whether the director they are dealing with has sufficient authority.

As between the company and themselves, directors will still have a duty to observe the company’s constitution, including any restrictions on the company’s activities.

Service addresses

All directors – and not just those at serious risk of violence or intimidation - will be able to provide a service address for the public record.

Appointment and eligibility

At least one director of every company will have to be a natural person.

The 70-year age limit for directors of public companies and subsidiaries of public companies will be abolished. There will be a 16-year minimum age limit for directors of all companies.

Private companies will no longer need to have a company secretary.

Personal liability

Derivative actions initiated by shareholders

As a general rule, if a wrong is done to a company, only the company itself (and not a shareholder) can bring an action for damages or some other remedy. In practice, the directors must decide whether or not to bring a claim. Clearly, if the wrong was done by the directors themselves, or a majority of them, no claim is likely to be pursued.

Unless shareholders are able to force the board to bring a claim, either by passing an ordinary resolution to replace the existing directors with new appointees, or by giving a direction to the board by means of a special resolution, the company and the shareholders will have no remedy in respect of any loss the company has suffered. Minority shareholders can therefore find it difficult to force directors to overturn their decision not to bring an action.

However, where it can be shown that an act amounts to a “fraud on the minority”, and that the wrongdoers are in control of the company, the courts have for some years allowed minority shareholders to bring a “derivative action” - in effect, allowing the shareholder to prosecute a claim on behalf, and for the benefit, of the company. Although fraud in this context is a wider concept than elsewhere, it is still difficult to prove, and a derivative claim can only be brought at the discretion of the court. Moreover, no claim can be brought where the act is capable of being ratified in general meeting. Many breaches of duty by directors fall into the latter category.

Because of the difficulty in bringing such claims, the Company Law Review recommended that derivative actions should be put onto a statutory footing. Clauses 239-243 of the Bill therefore provide that derivative claims may only be brought pursuant to a court order in proceedings for unfair prejudice under section 459 Companies Act 1985; or with the permission of the court where:

• claim is in respect of a cause of action “arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company” (including an action against a third party who has, for example, knowingly assisted the directors in a breach of duty);
• the court is satisfied that a (hypothetical) director acting so as to promote the success of the company for the benefit of its members as a whole would bring the claim; and
• the act or omission has not been authorised or ratified by the company (this will not be possible if carried only by virtue of tainted votes).

In deciding whether to give permission, the court must take various matters into account, including whether the shareholder is acting in good faith, the importance of the claim to the company, and whether the shareholder could bring a claim in his own right, rather than on behalf of the company. The court will be on the look-out for tactical use of the power (and will be able, for example, to step in if it turns out that the claim is being taken in order to prevent another person from taking action).

In effect, the court will have to put itself into the position of an independent director of the company and decide whether or not it is appropriate for a derivative claim to be pursued (although, as the court will have taken evidence to a forensic standard from all the interested parties and will have had counsel to take it through the precedents provided by case law, the analogy should not be pushed too far).

Until the new rules are applied in practice, it is difficult to know whether the number of derivative claims is likely to increase. It has been suggested that the possibility of bringing claims in respect of directors’ negligence or breach of duty, without having to show ‘fraud on the minority’, means that more claims are likely. But even activist shareholders are still likely to be discouraged from bringing such claims by the fact that any damages recovered will go to the company and not the shareholder personally. There is also the risk that, where the directors have taken advantage of the more liberal regime for directors’ indemnities, the shareholders may be facing a considerable hit to their investment if the claim fails or is settled out of court.

Application for relief

Under a section that will replace section 727 Companies Act 1985, if a director “has reason to apprehend that a claim will or might be made against him in respect of negligence, default, breach of duty or breach of trust”, he will be able to apply to court for relief without having to wait for the claim to be made.

Defective accounts; fraudulent trading

The Government has dropped a proposal to make the maximum sanction for approving defective accounts a term of imprisonment. Instead, the maximum penalty will be an unlimited fine. But the maximum prison term for fraudulent trading will be increased from seven to ten years.

Liability for offences committed by company

In the light of responses to its consultation, which criticised the proposals on both policy and technical grounds, the Government has decided not to extend to “senior executives” and “responsible delegates” the category of “officers in default” who can be made personally liable for acts and omissions of their company.

Corporate governance of listed companies

In anticipation of new European rules on corporate governance, the FSA will be given the power to make or amend Handbook rules (such as the Listing Rules) to implement any EC Directives on corporate governance that apply to companies listed on a regulated market.

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General meetings, resolutions and shareholder rights

Quoted companies

Shareholder rights to raise questions

Shareholders in quoted companies who hold at least 5% of the voting rights, or who number at least 100 (with an average of at least £100 of share capital each) will have the right to publish on the company’s website free of charge a statement of any concerns about the audit, or the circumstances in which the auditors have resigned, that they intend to raise at the AGM. But, contrary to the Government’s original plans, the auditors will not be legally obliged to answer shareholder questions.

A proposal in an earlier draft of the Bill to grant shareholders of quoted companies a right, within a 15-day “holding period” after the accounts become available, to propose a resolution to be moved at the general meeting where the accounts are laid has also been dropped. Instead, as originally proposed, shareholders in public companies will be able to require the company to circulate resolutions and any accompanying statement at the company’s expense (rather than their own) if the materials are provided to the company before the end of the financial year.

Exercise of voting rights

To make it easier for beneficial owners to exercise voting rights held by the registered holder (who is often a nominee or intermediary), all companies will be able to change their articles to allow registered holders to nominate someone else (such as the beneficial owner) to exercise some or all of their statutory rights as a member, including the right to receive notices of meetings and to appoint proxies. If sufficient companies do not change their articles to do so, the Government may make Regulations giving registered holders such rights automatically.

Unless voluntary shareholder engagement appears to be working in practice, the Government has also threatened to force institutional shareholders to publicly disclose their voting records. A few institutions have already started to do so voluntarily: for example, Fidelity International, one of the UK’s largest fund managers, has published its voting record at shareholder meetings on every motion proposed by companies in which it invests in the UK, Europe, the US and Asia between 1 July 2004 and June 2005.

Polls

Quoted companies will have to disclose the results of any poll on their website. Some quoted companies already do so as a matter of best practice. Shareholders who hold at least 5% of the voting rights, or who number at least 100 (with an average of at least £100 of share capital each) will be able to require the directors to obtain an independent report on any polled vote.

All companies

Proxies

Members of both private and public companies will be able to appoint more than one proxy. Proxies will be given the same rights as registered holders to ask questions, demand a poll and vote on a show of hands at general meetings (as well as on a poll).

Rights issues

The statutory minimum period of 21 days for acceptance of rights offers will be retained, but the Bill allows the Secretary of State to make Regulations to vary this period upwards or downwards (but to no less than 14 days).

Transfer of shares

Directors will have a statutory obligation to give reasons for any refusal to register a transfer of shares.

Class rights

Various technical changes will be made to simplify sections 125-127 Companies Act 1985 (variation of class rights).

New rules will also expressly allow companies to entrench provisions in their articles – i.e. stipulate that certain provisions cannot be changed at all or can only be changed if certain conditions are met.

Political Donations

Technical changes will also be made to the regime requiring companies to obtain shareholder authorisation before making any donation to an EU political party or organisation or incurring any EU political expenditure. The regime has been criticised for being too wide, so that it could catch various activities that would not normally be thought of as party political, and for requiring an excessive number of shareholder resolutions.

Among other things:

• private companies will be able to authorise donations and/or expenditure by written resolution;
• a holding company will be able to seek authorisation of donations and expenditure in respect of both the holding company itself and one or more subsidiaries (including wholly-owned subsidiaries) through a single approval resolution;
• a specific exemption will be introduced for donations to trade unions.

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Capital maintenance and transactions benefiting shareholders

Financial assistance

Private companies will be able to give financial assistance for the acquisition of their own shares or those of their (private company) parent, without having to go through the whitewash procedure (which will be repealed). But public companies will still be prohibited from giving financial assistance for the acquisition of their own shares or those of their parent company (whether public or private).

Directors will still need to consider whether a proposed arrangement is in the best interests of their company. But the removal of the threat of criminal sanctions for giving unlawful financial assistance is likely to simplify many M & A transactions that involve only private companies.

Reduction of capital

Private companies will be able to reduce their share capital by passing a special resolution, supported by a directors’ solvency statement signed by all the directors, rather than having to go to court. The statement will be similar to a statutory declaration of solvency for the purposes of a financial assistance whitewash under the current law.

Redeemable shares

The procedure for private companies to purchase or redeem their own shares out of capital will be retained, but as shares can be cancelled and non-distributable reserves returned to shareholders by means of a reduction of capital, the procedure will probably be used less often.

Shareholders in both public and private companies will be able to adopt articles that allow the directors to decide the terms on which redeemable shares are to be redeemed (rather than having to set out those terms in the articles). The terms of redemption must be decided before the shares are actually allotted.

Intra-group transfers and the rule in Aveling Barford

Section 577 of the Bill will make clear that assets can be transferred intra-group at their book value, rather than their market value, provided that the transferor has distributable profits. If an asset is sold at less than its book value, the company will need to have sufficient distributable profits to cover the amount of the undervalue.

Authorised share capital abolished

Concerns over whether a company has sufficient headroom to issue new shares will disappear, as the Bill abolishes the concept of authorised share capital. However, a proposal to allow companies to issue shares of no par value has been dropped: shares must have a fixed nominal value.

The existing requirements for public companies to have a minimum share capital will be kept.

Allotment of shares by private company

Unless its articles provide otherwise, a private company’s directors will no longer need shareholder approval to allot shares, although approval will be necessary if the company has, or will have as a result of the allotment, more than one class of shares.

Re-denomination of shares

A simplified procedure will allow limited companies to convert their share capital from one currency to another, and to re-denominate their shares after conversion to achieve round share values, without having to go to court or buy back shares out of capital and issue new shares.

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Auditors and accounts

Time limits for filing annual accounts

Private companies will have to file annual reports and accounts at Companies House within nine months of the year end (down from ten months at present), and public companies within six months (down from seven). (In a joint consultation paper published on 28 November 2005, HM Revenue and Customs and Companies House floated the proposal that the filing deadlines for company tax returns and private company annual accounts should be aligned at either seven months or nine months from the year end; alignment at seven months from the year end would, of course, necessitate a change in the Bill).

Limitation of auditors’ liability to company

Subject to annual shareholder approval, all companies will be allowed to limit the liability of their auditors to an amount considered by a court to be “fair and reasonable in all the circumstances” (i.e. an amount proportionate to their fault). When the Act comes into force, companies can expect their auditors to propose such limitations in their audit engagement letters.

A company that has entered into a liability limitation agreement with its auditors must disclose this in its annual financial statements.

Auditors’ duty of care

After consideration, the Government has decided not to codify in statute the principle expressed by the House of Lords in Caparo Industries plc v Dickman [1990] 2 AC 605 that the auditors’ statutory duty is owed to the company’s shareholders as a body, to enable them to exercise their rights in general meeting (for example, to approve or disapprove the election or re-election of directors, or the appointment or reappointment of the auditors), but not to individual shareholders or the public at large who may rely on the accounts when deciding whether or not to invest in the company.

Appointment of auditors

There will be a presumption that auditors of private companies will be automatically reappointed each year.

Resignation of auditors

A firm that ceases to hold office as auditor of a quoted company will always have to make a statement about the circumstances of its departure. The statement will have to be circulated to the company’s shareholders unless a court is persuaded that the auditor is “abusing his rights”. A copy must also be sent to Companies House and the Financial Reporting Council.

Quoted companies

Quoted companies will have to publish their annual accounts and reports and preliminary results on their websites.

True and fair view

Apparently in response to concerns that the introduction of IFRS and changes to UK GAAP are eroding the concept of the “true and fair view”, clause 366 of the Bill provides that the directors of a company must not approve annual accounts unless they are satisfied that they give a true and fair view. It also requires auditors to have regard to this standard in carrying out their audit. The existing requirement for auditors to state in their report whether or not the accounts give a true and fair view will be retained.

Audit report

Clause 494 of the Bill makes it a criminal offence for an auditor knowingly or recklessly to cause a misleading, false or deceptive audit report to be made. The maximum penalty will be an unlimited fine - not imprisonment, as originally proposed.

For the first time, the audit report will have to be signed by the lead auditor, as well as the audit firm. However, the risk attaching to this will be reputational rather than legal: section 492 provides that the signatory will not be subject to “any civil liability to which he would not otherwise be subject”.

Auditors’ terms of engagement

Regulations may be made in future requiring auditors or companies to publish audit engagement letters and/or details of the services provided by the auditors (and their associates) to the company, and the remuneration received.

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Company administration

Resolutions and meetings

Company decision-making processes will be streamlined. In particular:

• companies will not be required to lay their accounts or to appoint an auditor (if they have one) at an AGM. Companies that wish to continue to hold AGMs may do so.
• Public companies will have to hold their AGM within six months of their financial year end.
• Other than resolutions to remove a director or auditor, all resolutions of private companies will be capable of being passed in writing.
• Instead of needing unanimity, an ordinary resolution will be capable of being passed in writing by a simple majority of the total voting rights of eligible members; and a special resolution in writing by 75%.
• The percentage of shares or voting rights necessary to hold a meeting in a private company at short notice will be reduced from 95% to 90%.
• A company will be able to change its name either by special resolution or by any other means provided in its articles.
• Subject to shareholder approval, companies will be able to make electronic communications with shareholders the default position.

Formation of companies

Single member companies

It will be possible to have single member public companies, as well as private ones.

Constitution

The memorandum of association will be a brief document simply stating that the subscribers have agreed to become members and to take at least one share each. Other matters currently contained in the memorandum, such as the company’s objects, can instead be incorporated in the articles. For existing companies, such provisions will be treated as if they were in the articles.

The Secretary of State will be given power to prescribe articles that apply by default for all types of company, rather than just for those limited by shares. The Government’s consultation paper on the Bill included a new simplified set of model articles for private companies limited by shares. It also proposed the creation of separate sets of model articles for public companies limited by shares and private companies limited by guarantee. Such model articles are likely to be set out in secondary legislation, and are therefore not included in the Bill itself.

When the new model articles are introduced, they will apply automatically to companies that are incorporated after that date, but not to companies incorporated beforehand. In both cases, shareholders will be able to choose to adopt all or any part of the new model articles.

Company names

New provisions will enable a person to object to a company’s name if that name is the same as, or confusingly similar to, a name in which the objector has goodwill. The objection will be upheld if the name was not adopted in good faith or if the main reason for its choice was either to obtain money from the person objecting or to prevent their using the name.

Business names

The Business Names Act 1985, which governs the use of trading names by certain companies, partnerships and sole traders, will be repealed and replaced with similar provisions.

Private companies offering shares to the public

A private company that is intending to re-register as public will be able to offer shares to the public without waiting for the re-registration to complete. The definition of “offer to the public” currently in section 742A Companies Act 1985 (which is quite different to the definition used for prospectus purposes) will remain largely unchanged.

Paper-free holding and transfer of shares

The Bill extends the power under section 207 Companies Act 1989 for the Secretary of State to make Regulations providing for shares to be transferred electronically. This power has previously been used to make the Uncertificated Securities Regulations 2001, which enable shares in quoted companies to be transferred through CREST. It will now enable further regulations to be made requiring, as well as permitting, any specified type of company to provide for its shares to be held and transferred electronically. Such regulations will only be introduced after further consultation.

Inspection of the register of members

A request from any person to inspect a company’s register of members need not be complied with if the company can persuade a court that the request is not made for a “proper purpose”.

Companies House filings

There will be a new offence of knowingly or recklessly delivering information to the registrar of companies that is misleading, false or deceptive in a material particular.

From 1 January 2007 it will be possible to incorporate a company on-line, and companies will be able to file documents and particulars electronically.

The Registrar will be given limited powers to accept informal corrections to, or replacements for, documents that have been filed. At present, the formal position of Companies House is that corrections or replacements can only be effected pursuant to a court order.

Conclusion

The Bill will bring about the biggest changes to English company law for over twenty years. If the Bill is passed during the current session of Parliament it could become law as early as October 2006. However, the Department on Trade and Industry has acknowledged that there may be a case for deferring some parts to a later date to allow companies and advisers time to digest the implications. It is more likely that the bill will come into force in April or October 2007.