Part 2: Directors – the duty to act in good faith and in the best interests of the company

Part 2: Directors – the duty to act in good faith and in the best interests of the company

Directors of companies have a unique “fiduciary” role. A fiduciary, acting on behalf of stakeholders and in relation to a company, is in a position of power, trust and confidence with respect to the company and is required to act solely in the interests of the company, whose rights it must protect.

As mentioned in the first article of our series, the fiduciary is a concept developed in law as having the following duties (set out in the Companies Act):

  • the duty to act in good faith;
  • the duty to avoid conflicts of interests;
  • the duty to act for a proper purpose; and
  • the duty to act in the best interests of the company.

It is helpful to understand each of these concepts by looking at how they are tested when a director’s actions are measured by a court.

The first element of good faith is quite subjective. This means that the courts will go through a process of enquiring whether the director genuinely believed that his/her conduct was in the best interest of the company. When making this decision, courts will take into account:

  • the relevant facts available to the director at the time;
  • his/her level of skill;
  • the expected level of diligence and care in such a situation; and
  • whether their actions were reasonable.

A proper purpose is not defined in the Companies Act, however the courts’ approach is to test whether the directors exercised their powers for an objective purpose. The court will first look for factual evidence (i.e. objective evidence) for the purpose of the director’s appointment. This will largely involve understanding the purpose of the company by looking at its Memorandum of Incorporation, shareholders agreement and historical decisions by shareholders and the board (through written resolutions). Once the courts understand the purpose of the company, and how the director’s appointment was intended to further that purpose, they can then test the director’s actions against this.  If the director’s actions do not have any rational link to furthering the company’s purpose, their actions may be considered to have been for an improper purpose.

A director’s fiduciary duties extend to the duty not to place themselves in a position where their personal interests conflict, or may conflict, with their duty to act in good faith. An obvious and important element of this duty is the obligation not to compete with the company and to avoid a conflict between a director’s interests and the interests of the company.  Effectively, this means that every director has an automatic non-competition obligation with the companies that they serve.

Acting in the best interests of the company means to act for the benefit of the company as a whole. There has been much debate as to what this means. However, this does not mean just acting in the best interest of the shareholders. Rather, this can also mean acting in the interests of “stakeholders” including employees and creditors.

There are various approaches to determine what directors should take into account when making decisions on behalf of the company, and whether the factors taken into account should have regard only for the benefit of shareholders or for the benefit of all stakeholders. The King Code, which is only mandatory in respect of listed companies, has attempted to clarify this by promoting the principles of corporate social responsibility, which require companies to act in a socially responsible manner by making decisions which will benefit both the company and other stakeholders.

If there is a dispute around whether a decision taken by a director was in the best interests of the company, the courts will apply the “business judgement rule”. They will consider what the director believed at the time in light of their general knowledge, skill and experience. The director will have satisfied the duty to act in the best interests of the company if s/he:

  • took reasonably diligent steps to become informed about the matter;
  • had no personal financial interest in the subject matter of the decision (and had no basis to know that any person/entity related to the company had a personal financial interest in the company);
  • had a rational basis for believing that the decision was in the best interests of the company.

It has been acknowledged by the courts that companies should not be over-regulated, and that directors should have the legal authority to run companies as they deem fit, provided that they act within the legislative framework. In other words, the Companies Act tries to ensure that it is the board of directors, duly appointed, who run the business rather than regulators and judges, who are never best placed to balance the interests of shareholders, employees, creditors and the larger society within the context of running a business. Accordingly, the business judgement rule could be used to absolve directors from liability, if:

  • they acted in good faith; and
  • adopted a course of action which they honestly and reasonably believed would benefit the company.

However, any director who fails to act in the best interests of the company with intellectual integrity, honesty and independence of mind and without any conflict of interest could not rely on the business judgement rule.

In the next article, we will dive into the qualification that applies to directors in the course of carrying out their duties. Specifically, that they should, and can only be expected to carry out their duties, with the degree of care, skill and diligence that may reasonably be expected of a person carrying out the same functions in relation to the company as those carried out by that director; and having the general knowledge, skill and experience of that director.