Turkish Law Blog

Wrongful Behaviour and Directors’ Authority as a Constraining Mechanism

Samet Çalışkan Samet Çalışkan/ Newcastle University
15 July, 2019
427

Introduction

Directors, as principal officers, are empowered with an extensive authority to run a company and such an authority can be used for good or ill. The limitations placed on directors’ authority to enter into a binding transaction can constrain them regarding their involvement in wrongful behaviour. In order to determine the existence of such limitations, there is a need to examine how the company is typically run by the board of directors, and how their authority is regulated.

A public limited company’s ‘decision-making structure is principally an authority-based one’.[1] This leads to a ‘board-centric form of corporate governance’ which Bainbridge identified as ‘director primacy’.[2] Although the board of directors in modern companies is an organ invested with great decision making power for the running of the company, it does not normally take all day to day decisions by itself. Its power is allocated to a particular director who automatically becomes responsible for a specific task, and this allocation is recognized by statute and common law.

Articles of Association

In the UK, companies registered after 1 May 2009 can design their articles of association based on the Model Articles, and Table A for companies registered before this date, and they both confer authority on directors to bind the company and authorize others. Regulations 70–72 of Table A provide authority to directors to delegate their powers and allocate their responsibilities. Regulation 70 states that,

Subject to the provisions of the Act, the memorandum and the articles, and to any directions given by special resolution, the business of the company shall be managed by the directors who may exercise all the powers of the company…The powers given by this regulation shall not be limited by any special power given to the directors by the articles and a meeting of directors at which a quorum is present may exercise all powers exercisable by the directors.

Also, under Regulation 71, directors can appoint any person to act as an agent of the company, and he/she may be authorized to allocate such powers to others. Under Regulation 72, directors can also delegate their powers to other directors designated to manage specific tasks. Although the Model Articles modified Table A, the wording is still similar. While Article 5 of the Model Articles empowers the board of directors to delegate its powers to any director, and to other individuals, Article 3 also confers the responsibility on directors to manage the company and determines the breadth of their powers.

The Statute and Common Law Approach

The authority of directors is regulated under the statute and common law. The common law approach to the authority of directors is established from a long line of decided cases culminating in Royal British Bank v Turquand.[3] In this case, the company alleged that the activities conducted by its manager were invalid as he had no authority to perform the transaction under the company’s deed of settlement, having not obtained the ordinary resolution required to authorize a director’s action. Despite this, the company was held to be bound by its manager’s conduct, based on the reasoning that the claimant believed that the manager had complied with the required resolution at the time of the transaction.

This reasoning was also supported by Lord Hatherly in the House of Lords in Mahony v East Holyford Mining Co,[4]  such that,

[W]hen there are persons conducting the affairs of the company in a manner which appears to be perfectly consonant with the articles of association, then those so dealing with them, externally, are not to be affected by any irregularities which may take place in the internal management of the company.[5]

This common law attitude was adopted by the statutory law and the authority of directors was regulated under Section 35A of the Companies Act 1985 (CA85), codified under Section 40 of the Companies Act 2006 (CA06). Despite the codification, the wording of Section 40 remains similar to Section 35A of the CA85. This provision generally recognizes that statutory authority belongs to directors, and the option of setting up certain restrictions on them is left to the discretion of the company through its articles of association.

Section 40(1) states that ‘in favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorize others to do so, is deemed to be free of any limitation under the company’s constitution’. In addition, Section 40(2) explicates this issue further, in that a third party dealing with the company is not responsible for inquiring into the limitations on the authority of directors to bind the company or to delegate such powers to others.

In a broad interpretation, these provisions may arguably override the limitations placed by the articles of association on the power of directors in favour of third parties.[6] While they enhance the authority of directors to bind the company, they may decrease the ability of the company to avoid being bound by the transaction made by the directors. Even if the company seeks to avoid a contract by alleging that its directors were not authorized to act at the time in question, such an argument is, as Dignam considered, ‘unmeritorious’.[7] This is because the courts have developed the attitude that the company is ordinarily bound by the conduct of its directors, who are presumed to be authorized by the company to embark on that particular task.[8]

In addition, the statement that ‘a person dealing with a company is not bound to enquire as to any limitation on the powers of the directors to bind the company or authorise others to do so’, under Section 40(2)(b)(i), illustrates that employees and agents can be delegated by the director to act on behalf of the company, and a third party dealing in good faith may assume that such delegation is valid.[9] In respect of the wording under Section 40(1), despite the fact that companies are deemed to be free to limit the power of directors to enter into a binding transaction, there is no statement that provides powers to the company to limit the power of any individual to act on its behalf.[10] Thus, the statute’s purpose is to enhance the discretion of the directors to bind the company and also authorize others to act on its behalf.

Another issue with Section 40 is that power is conferred on the directors instead of the board of directors. The unanimity of the directors as a board is arguably not required in the statute and the intention of lawmakers behind this is probably to ensure that the third party dealing with the company can still rely on the decision, even if the decision has been taken by the improperly constituted board or de facto directors.[11] Protecting the third party dealing with the company is actually ‘the obvious intention of the legislation’ and despite the fact that the legislation is ‘ill-conceived and not well-drafted’, ‘the courts will make the best of it…to diminish the circumstances in which the third party is adversely affected by limitations contained in the constitution’ when it has to make a decision on the meaning of the statute.[12] Accordingly, protecting the interests of the third party rather than that of the company is likely to be the priority consideration of the courts. This may impair the power of the company over directors, as it would not be able to avoid the negative consequences of a binding transaction in which they are involved.

The Requirement of Good Faith

The only restriction that the company can invoke to avoid the consequences of directors’ behaviour is the requirement to prove bad faith on the part of the third party. This is because, in order for the action of the director to bind the company, Section 40(2) of the CA06 requires third parties to act in good faith when involved in a transaction. Therefore, the company can still avoid being bound by the consequences of directors’ behaviour if the third party has entered the transaction in bad faith. However, there are certain difficulties in the statutory law that the company must overcome. Firstly, the statutory law presumes that ‘a person dealing with a company…[has] acted in good faith unless the contrary is proved’.[13] Nevertheless, based on the wording in Section 40(2)(b), the third party dealing with the company is almost always presumed to be acting in good faith for the purposes of Section 40[14] and leaves the burden of proving the third party’s bad faith on the company. In addition, Section 40(2)(b)(iii) states that the third party ‘is not to be regarded as acting in bad faith by reason only of his knowing that an act is beyond the powers of the directors under the company’s constitution’. Based on this provision, the third party would not be regarded as acting in bad faith even if they entered into the transaction knowing that there were limitations placed on the authority of the director in the company’s constitution. These issues potentially decrease the ability of the company to avoid being bound by the transactions in which its directors are involved, and it may consequently be exposed to the risk of liability and loss caused by directors’ wrongful behaviour. 

Besides this issue, in respect of the company’s ability to prevent directors’ wrongful behaviour, the control mechanism over directors’ authority may not be adequate in all circumstances that expose the company to risk. This is because this mechanism can only assist the company when directors are involved in a contractual relationship with a third party. The concept of directors’ wrongful behaviour, however, is not limited to third party transactions, and mainly involves regulatory wrongdoings that do not require contractual relationships with a third party. Therefore, even assuming that the authority of directors is a control mechanism that effectively deters them, this mechanism would only be invoked by the company to avoid being bound by a contract entered into by its directors with third parties. This is based on the reasoning that either the commercial business judgment made by the directors is not for company benefit, or they entered into the contract to enrich themselves at the company’s expense. These types of behaviour can still be considered undesirable and excessive risk-taking by directors, but they are outside the scope of this article.

Conclusion

The problem of directors’ wrongful behaviour may arise where the power delegated to a particular director is exercised without adequate limitation. Providing authority to directors is required since they run the company’s business on behalf of the shareholders; however, the far-reaching authority may lead to wrongful behaviour which causes the company to be subjected to risk. Wrongful behaviour by directors can still bind the company and the limitations placed on directors’ authority under the company’s constitution are overridden by statutory law and common law due to the tendency to protect third parties. Consequently, the company is unlikely to prevent its directors from behaving wrongfully through the control mechanism of directors’ authority. The limitation of this approach is that it does not capture instances where directors expose the company to serious risk.


[1] Stephen Bainbridge, ‘Director Primacy’ (UCLA School of Law, Law-Econ Research Paper No 10-06, 2010) 7. Available at <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1615838> accessed 15 May 2018.

[2] Stephen Bainbridge, ‘Director Primacy’ (UCLA School of Law, Law-Econ Research Paper No 10-06, 2010) 3. Available at <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1615838> accessed 15 May 2018.

[3] Royal British Bank v Turquand (1856) 6 E&B 327.

[4] (1874–75) LR 7 HL 869

[5] (1874–75) LR 7 HL 869 [894].

[6] Susan McLaughlin, Unlocking Company Law (3rd edn. Routledge, 2015) 303 and 305.

[7] Alan Dignam, Hicks & Goo’s Cases and Materials on Company Law (7th edn. Oxford, 2011) 245.

[8] Alan Dignam, Hicks & Goo’s Cases and Materials on Company Law (7th edn. Oxford, 2011) 245.

[9] Adam Goodison, ‘Directors’ Powers and Responsibilities’ in Simon Mortimore QC (ed.) Company Directors Duties, Liabilities, and Remedies (2nd edn. Oxford, 2013) 76, 87.

[10] Susan McLaughlin, Unlocking Company Law (3rd edn. Routledge, 2015) 305.

[11] Paul Davies and Jonathan Rickford, ‘An Introduction to the New UK Companies Act’ (2008) 5 ECFR 48, 59.

[12] John P. Lowry, and Arad Reisberg, Pettet’s Company Law: Company Law & Corporate Finance (4th edn. Pearson, 2012) 137.

[13] Companies Act 2006, s 40(2)(b)(ii).

[14] Susan McLaughlin, Unlocking Company Law (3rd edn. Routledge, 2015) 303.

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