Company Directors – Keeping better company

From time to time, everyone working in business or the professions comes across a company director who is not up to the task of running a small to medium-sized company because of ignorance, inexperience or incompetence.

The courts ban hundreds of directors each year.

How does this situation arise? Most commonly because someone who has excelled at another aspect of business (sales or project management perhaps) has been invited to join the board of directors – either as a pre-emptive gesture to prevent them leaving or as part of their reward package.

All too often they accept, and take a seat on the board without a moment’s thought – or training – for the responsibilities the position entails.

Many directors have virtually no idea about the scope of their powers or the legal obligations that they face. They expect to learn from the incumbents who arrived there by the same route – the blind leading the blind.

In the belief that businesses are national assets too valuable to be run by amateurs, the government instructed the Law Commission to canvass key members of the business community on the subject – the intention being to introduce what some people consider long-overdue reforms to the 1985 Companies Act.

The commission has duly produced a consultation document on regulating company directors and formulating a statement of their duties under general law – a summary of which appears in the DTI’s recent company law review.

Similar reports were prepared in 1992 (Cadbury), 1995 (Greenbury), and 1997 (Hampel). And although the Law Commission will ultimately take their findings into account, they have previously fallen on deaf ears in Westminster.

At the risk of being accused of consulting the offenders themselves about how to reform the law, this government seems determined to make changes.

The trouble with seeking the counsel of qualified, competent directors from major plcs is that they are the least likely to have hands-on experience of the shortcomings and abuses outside their ivory towers.

It’s in the world of owner-managed concerns and the myriad enterprises employing less than 50 people that the problem of unfit directors is most acute. At its root is the disparity between the elements of company governance enshrined in common law and equity, and the parts on the statute book. As a result, there is a no-man’s land – inhabited by corporate lawyers and the DTI – engaged in the time-consuming, implausible and prohibitively expensive business of banning offending directors from participating in the affairs of companies.

The penalties for ignoring a ban are hardly a deterrent. Banned directors – who frequently retain an interest in the companies they have misused – may continue to do so with consummate ease. Is it any wonder the public perception of companies and company law is of a rogue’s charter?

Examples of the rules directors commonly break – either deliberately or unintentionally – include: borrowing money from companies over which they exercise control; failing to hold and minute board meetings as and when required by law; failing to declare an interest in contracts that involve the company; blindly battling to save a company in difficulties or technically insolvent when this presents a risk to the creditors; failing to understand the ‘five year’ directors’ employment contracts rule.

The question arises as to whether directors should be tested to ascertain their competence before being granted permission to serve. In other words, should the government introduce a legally binding ‘L-test’, through which business people would be licensed to run a company, along the lines of being licensed to drive a car?

‘Too complex, too cumbersome, too expensive and impossible to enforce,’ say the detractors (among whom Lord Hoffman is numbered). Businesses would simply not incorporate in those conditions.

Not so, say the move’s supporters. A clear set of rules – to which directors must adhere – could be constructed in such a way as to make it obvious when they were failing in their duties.

Prevention could then take the place of retribution.

My own view is that most directors are broadly aware of the statutory requirements of the Companies Act, and reasonably competent in applying it.

It is in the sometimes vaguer areas of common law and equity that implicit obligations are overlooked. This is where our efforts towards greater understanding and competence need to be directed.

As well as considering the case for writing a statement of directors’ duties into general law, the Law Commission has raised questions as to whether there should be objective tests for directors to determine that they have sufficient skills and experience to exercise an appropriate standard of care.

One solution would be to introduce two codes of practice with the force of the law behind them. One would apply to publicly quoted companies; another less stringent and complex framework for private companies. Since self-regulation of small to medium sized private companies has manifestly failed to work, the cost of regulation could then be channelled to where the need is greatest.

The big fish, and their ever wary investors, shareholders, qualified financial directors, lawyers and bankers, are quite capable of dealing with wayward directors without the protection of state nursemaids.

What is crystal clear is that radical reforms are needed. The minor tinkering with the Companies Act that has taken place over the last 15 years or so is clearly inadequate. Equally inadequate is the government’s passing of responsibility to the courts, hoping that judges will reform the law and adhere to precedent.

In relying on the courts and judges, the government has failed to appreciate that most cases involving directors who have behaved inadequately are brought under the Companies Directors Disqualification Act (1986) in the County Court, or are criminal cases dealing with the all too frequent criminality of miscreant directors.

The judges in these cases are not sitting in precedent setting courts in the true sense. Very few such cases reach the Court of Appeal, and so judges very rarely have the opportunity to reform a failing system.

In any event, it would not be an option for the court to set out preventative measures which will force directors to prove their competence prior to taking up the position. This brings us back full circle to the need for the government to completely re-organise and re-draft the statute book.

Critics respond by saying that to require directors to take an ‘L-test’ – or requiring them to demonstrate their competence – would lead to them find other, unregulated ways of conducting business.

What seems to be overlooked by this argument is one of the requirements of a limited company’s annual audited accounts. These must be compiled by a registered auditor and a certificate from that auditor must accompany them.

Clearly this is a regulation which would be far too onerous for company directors seeking to avoid regulation. This has not stifled industry, however, nor caused companies to find other ways of doing business where they don’t have to file audited accounts.

If there is a statutory requirement for audited accounts to be filed, then why can’t there be a statutory requirement for certificates of compliance and competency? To take the argument one stage further, why can’t certificates of competency – or another method of demonstrating suitability for directorship – be a pre-requisite for becoming a director of a limited or public limited company?

Banning directors does not prevent disqualified directors from running businesses. They can still be controlling shareholders and organise and operate their business via a nominee director or by adopting titles such as ‘operations manager’ and doing exactly what they were doing before they were disqualified.

Companies could be required to detail the persons who operate the company – regardless of their position. This would allow a government agency to monitor the operation of companies and ensure that people – whether or not with the title of ‘director’ – do not repeatedly put companies and creditors at risk.

I believe this simple requirement would have a positive effect on industry, generating the all-important investor confidence that the government tells us brings investors to the UK Stock Exchange.

It is time for the government to show British industry – and the rest of the world – that it is willing to prevent unsuitable people from taking control in the first place.

A competency test would also offer the banks more criteria upon which to base their lending, and avoid the need for managed exits by prospective bad-debtor companies from one bank to another on an all-too-regular basis.

That, in turn, would save the millions wasted each year writing off debts from companies that go into liquidation.

The ramifications do not end there. Currently, at any one time in Manchester, about #600m is owing between businesses because of late payment of invoices.

The government has reacted by creating the Late Payment Act, which allows companies to charge higher interest rates on outstanding debts. But the problem is not with the rate of interest that can be or should be charged, but rather with the businesspeople who are controlling the companies and refusing to pay.

Once again, although professional competence will not be sufficient to ensure that business people never use trade creditors as unofficial overdrafts by simply not paying invoices, it would surely be a step in the right direction to – at the very least – ensure that there are competent and suitable people running the companies with which others have to trade.

Related reading