Directors’ duties in the context of family office-invested private companies: practical guidance from legal expert
With more and more family offices taking a more active role in managing their investments, for many this can also involve taking a seat on the board of an investee company. However, there are legal implications for a director who does not have full visibility of the operations of the company.
In this analysis, James Parker, Partner at global law firm Norton Rose Fulbright shares some practical guidance for directors to avoid pitfalls.
It is well-known that family offices have been investing increasingly in private companies. In fact, family offices allocated a sizeable 22 percent of their portfolios globally to investments in private companies in 2023, of which half were direct investments.
There is good reason for this. Unlike many funds, a family office is not constrained by timeframes in which to return capital to investors, meaning that they can invest for the long haul in relatively illiquid private companies, which may deliver higher returns over time.
For such families, appointing investment professionals as directors of investee companies helps achieve a degree of control and oversight. However, questions then arise as to the extent of these directors’ duties. Are these directors judged to the same standards as an executive director in the eyes of the law? What is the standard of care and diligence required, given that they are often not involved in the day-to-day running of the company?
These questions can be answered in principle by looking at what it says about directors’ duties in the UK Companies Act 2006 (CA 2006). However, certain arguments raised by the UK government in the recent Carillion case demonstrate the danger to directors of having their conduct judged through the lens of hindsight. We conclude by offering some practical guidance for directors to avoid pitfalls.
Directors’ duties under CA 2006
In the UK, directors’ duties are codified under CA 2006, which prescribes, among other things, the duty to exercise reasonable care, skill and diligence (section 174) and the duty to promote the success of the company (section 172). These statutory provisions make no legal distinction between different “types” of directors. In principle, therefore, directors appointed by family offices owe the same duties to the investee company as other more active directors.
Duties to the investee company vs duties to the appointor
Directors appointed by a family office to the board of an investee company may be expected by their principals to owe them a degree of loyalty and act in their interests. However, section 172 CA 2006 clearly states that a director must act in the best interests of the company itself, rather than their appointor.
What’s more, under section 175 CA 2006, a director must also avoid a situation where they have a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company. The English courts have interpreted these rules strictly, regarding the duties owed to the company as paramount. Therefore, whilst a shareholder’s interest and the company’s interest are for the most part aligned, where conflicts of interest do arise, the director must prioritise their duty to the company over their loyalty to the appointor.
In the case of Hawkes v. Cuddy, the Court of Appeal considered the duties a nominee director owes to the company vis-à-vis the duties to their appointor. It was held that the fact that a director has been nominated to that office by a shareholder does not, in itself, impose any duty on the director towards their appointor. Such duty can only arise out of a separate agreement or office.
It was also noted, however, that a nominee director could – without being in breach of their duties to the company – take the interests of their appointor into account, provided that they genuinely consider this to be in the best interests of the company. This case demonstrates the courts’ willingness to adopt a more realistic approach, recognising the commercial functions of nominee directors.
What is the standard required to fulfil the duty to exercise reasonable care, skill and diligence?
Directors appointed by investors often leave the operations of the company to other directors and play little or no active part in the day-to-day running of the business. Such was the case in Secretary of State for Business, Energy and Industrial Strategy v. Selby and Others, where Mr Bamford, a non-executive director of a company, faced disqualification claims for his alleged involvement in the company’s VAT fraud.
The court observed that, while the duties owed by executive and non-executive directors are the same, “their application need not be”Indeed, the wording of section 174 CA 2006 makes it clear that the standard of care, skill and diligence is measured in both objective and subjective terms. The objective standard, being a minimum standard, turns on what is expected of a reasonable director carrying out the same functions, whereas the subjective standard looks at the actual experience, skill and knowledge that the individual director has.
It follows that the assessment turns on the actual role of the director, as well as their personal skillset, and the title they carry is not necessarily conclusive as to function. To quote from Lord Hoffmann, the section 174 CA 2006 duty “must depend upon how the particular company’s business is organised and the part which the director could reasonably have been expected to play”.
It is therefore acceptable for directors who have not been appointed for their financial expertise to rely on information provided by other directors and managers with more active involvement or expertise. However, the ability to delegate does not translate into a blanket exemption from exercising oversight and making appropriate enquiries.
In Mr Bamford’s case, one of the allegations was that there had been an extraordinary uplift in the company’s turnover connected to fraudulent evasion of VAT, which he should have investigated, but turned a blind eye to. The court considered several factors, including the role he was expected to play, which was to “look after the interests of the shareholders”; the fact that he did look at the company’s accounts occasionally; and that he took two years to familiarise himself with the product and business. After considering these factors, it concluded that to not investigate with thoroughness the huge leap in turnover was a “reprehensible abrogation of duty”.
Is there a “duty to know”?
To what extent must a director, despite their limited role in running the company, know about the financial position of the company? This question was considered in the recent disqualification proceedings connected to the insolvency of Carillion plc, the construction giant that collapsed into liquidation in 2018. The government brought the claim against its former directors, arguing that there was a strict, unqualified duty on all directors to know the true financial position of Carillion at all times, even if that true position was not set out in the accounts.
There is, however, no legal authority in support of the government’s position. The directors argued that a strict duty to know would be inconsistent with, and would contradict, the codification of the section 174 CA 2006 duties. What’s more, they said that such duty – if imposed on all directors – would be practically unworkable and impossible to comply with, especially in large companies where information could be deliberately hidden from a director. It would also eradicate the role of non-executive director from the landscape of UK corporate governance, as few would be willing to act as non-executive directors if they were to be subject to an onerous duty to know the company’s financial position inside-out. While the debate continues, the government’s eventual abandonment of the claim suggests there were substantial merits in the defence.
The threat of reviewing conduct through the lens of hindsight and practical lessons
As seen from the Carillion proceedings, directors are often judged, either by authorities or in the court of public opinion, by people who enjoy the benefit of hindsight. They may be accused of not asking the right questions, even if they have not been provided with the necessary information or tools to do so, or the issue has arisen from circumstances that are beyond the director’s control. With this in mind, we set out below some practical tips for nominee directors to mitigate risk:
- Clearly define the director’s role in the letter of appointment. The standard of care applicable to each director will depend on the specific role assigned to them and the particular circumstances. Accordingly, the more clearly drafted the director’s roles and responsibilities, the better case a director will have in arguing that their duties have been discharged in accordance with the letter of appointment.
- When delegating matters to the expertise of others, make sure information is supplied to the director as a source of reliance. While directors may delegate responsibilities, they must obtain sufficient information to enable them to make informed decisions in supervising the company’s affairs and the delegate’s actions. Such information should be concise, clearly set out in a manner that is comprehensible to the director, and contain the necessary context, so a director who is not involved in the business day-to-day can form an educated opinion on the issue at hand. It is recommended to place rules and protocols for requesting information from appropriate sources and keep written records of such requests.
- Focus on supervision of systems and strategy over individual decisions. Directors performing non-executive functions are often tasked with supervising management. Supervising the making of individual decisions can be challenging, especially in business-as-usual situations when it is more difficult to call in specialist support than during times of crisis. Supervising systems and strategy is a more realistic role for a non-executive director, which should fall within their time and resource constraints. Where a high-level decision is controversial or significant, board minutes should capture the detailed considerations of the directors and the factors they evaluate.
- Have good Directors and Officers (D&O) Insurance in place.
D&O insurance can cover the cost of defending claims made against directors by shareholders, investors, regulators or third parties, and potentially any compensation costs that arise from an unsuccessful defence. While directors should of course seek to avoid a breach of their directors’ duties, a good D&O insurance policy can act as a safeguard against significant economic liabilities.
In summary, directors representing their investor at board level in an investee company are expected to understand their duties under the law. Statutes and case law both lay down clear rules on conflicts of interests and to whom a director owes a duty. In setting the bar for reasonable care, skill and diligence, the law also recognises the diversity of functions performed by directors, taking into account the unique circumstances of each case.
For directors, aids to navigating safely around so-called “unknown unknowns” include having clearly defined duties, efficient and informed delegation and monitoring protocols, and conducting visible diligence at a systemic level, rather than micro-management.
