A Perspective to Foundations of Corporate Governance

Introduction

In this assessment, the judgment of Romer J in the Re City Equitable [1925] Ch 407 case will be evaluated in terms of the duties of care and skill of company directors, considering the background of the decision and in the context of some modern Corporate Governance norms.

To determine whether Romer J's decision in Re City Equitable [1925] Ch 407 still reflects modern legal and economic perspectives, several topics need to be addressed. In this context, after presenting the facts and the core decision of the case, developments and contemporary approaches to the norm will be discussed. Finally, the current state of this area will be evaluated. Therefore, initially, after presenting subjective and objective tests concerning directors' duties of care and skill, the facts of the case and the relevant context will be explained.

Subjective and Objective Tests

One view posits that a director’s duties of care and skill should be that a director owes the company the care, diligence, and skill that a reasonable person with the director's knowledge and experience would exhibit. This view has been seen as a traditional perspective for evaluating duties of care towards the end of the twentieth century. In this context, the Re City Equitable case, which is the subject of this assessment, has been examined from this perspective. This perspective considers the personal responsibilities of the director and the specific circumstances of the company. According to this view, subjective standards are considered lower when the director does not have significant knowledge and experience, while they are seen as higher than objective standards for some directors with special expertise.

In the described view, subjective standards may be appropriate in some cases because management may not be professional. Directors may not require specific skills to perform their duties. It is also noted that a company may appoint a person as a director knowing that they may lack skills in commercial matters.

On the other hand, there is the view that a director owes the company the care, diligence, and skill that a reasonable person with the general knowledge, skill, and experience reasonably expected of someone in their position would exhibit, regardless of their specific expertise.

In addition to these two approaches, there is another hybrid approach highly relevant to this assessment's subject. This approach is called the dual objective/subjective test. Briefly, according to this approach, when evaluating directors' responsibilities regarding their duties of care and skill, both personal circumstances and objective matters should be considered together in each case. Below, the dual test evaluation approach will be presented within the framework of the development of duties of care and skill, especially on a case-by-case basis over the years.

Facts of the Case and Relevant Statements by Romer J

Re City Equitable or more commonly known as Re City Equitable Fire Insurance Co [1925] Ch. 407, is actually a decision of the Court of Appeal. However, since the Court of Appeal only dealt with the responsibility of the auditors, the case has always been initially known by the decision of Romer J. Romer J's decision concerned a chairman named Gerrard Lee Bevan, who was the managing director of City Equitable Fire Insurance Company Ltd on June 27, 1916. According to the case, the company suffered a significant financial loss of about £1,200,000 over six years due to the chairman's fraud. The official receiver sued the directors for negligence regarding transactions and dividend payments. In the case, according to a clause in Article 150 of this company, they could only be held liable for losses resulting from "willful neglect or default." Consequently, the lawsuit against all directors except Bevan failed. The issue stemmed from leaving the management of the company entirely in the hands of Chairman Bevan. According to the claimants, Bevan committed fraud by buying Treasury Bills at the end of the period and selling them immediately after the audit report. By using this method, the debt owed to the company from a firm in which the chairman had an interest was intensified by increasing the assets in the balance sheet.

On the other hand, the importance of the case was that Romer J wanted to outline the fundamental features of the duties of care and skill of company directors. In parts of his explanation, Romer J's focus was that directors should act honestly in accordance with the standards reasonably expected of persons with their knowledge and experience. This explanation can be considered a subjective test because the issue of responsibility was built upon the directors' knowledge and experience. Secondly, a director is not required to give continuous attention to the affairs of their company. This statement provides us with some objective norms, as it is an explanation by Romer J about directors' duties with a general perspective unrelated to their personal circumstances. Finally, Romer J stated in his decision that such persons could delegate responsibilities to other company officials when there was no reason to suspect mismanagement. Romer J also made a similar decision in the Lagunas Nitrate Co. v. Lagunas Syndicate [1899] 2 Ch. 392 case, suggesting that directors, if they act honestly for their companies, can be presumed to have acted fairly and fulfilled their legal duties, taking into account the knowledge and experience reasonably expected of them. As in the Re City Equitable case, Romer J established some criteria regarding the actions and personal circumstances of directors in cases. Until Re City Equitable, the prevailing view on this matter was that only objective criteria (held later in Re Brazilian Rubber Plantations and Estates Ltd, 1911) or subjective criteria could be used to evaluate directors' responsibilities. By making this explanation, Romer J showed that there could be other evaluation criteria beyond just subjective or objective norms.

Process of Reasonable Duties of Care and Skill and Re City Equitable

The approach up to the Re City Equitable decision was to see directors as amateurs, neglectful, and exempt from such responsibilities. In the context of cases in the nineteenth century and the first quarter of the twentieth century, it is possible to speak of duties of care and skill for non-executive directors. According to relevant cases, non-executives were not in an active position in companies. The importance of Romer J's approach can be examined in terms of combining objective and subjective norms for directors' duties of care and skill until the late 1980s. It can be said that the director's duties discussed in today's modernized professional context are stricter.

In this context, it can be said that in the years when the Re City Equitable decision was made, directors' duties were examined in terms of subjectivity or objectivity. However, in the Re City Equitable decision, "the standards reasonably expected of persons with their knowledge and experience" and the other two explanations mentioned above can still be considered a standard in the modern corporate governance context. In today's modernized corporate governance perspective, it can be said that objective and subjective criteria are the core essence of directors' duties of care and skill. Although today's modern perspective has three dimensions (objective, subjective, and dual), it can be clearly stated that the dual approach for directors' duties was first comprehensively presented, especially in the Re City Equitable decision. In those years, it was quite common to evaluate directors' duties with either subjective or objective criteria. However, it can be said that Romer J's decision was not as effective as the necessity of today's dual approach.

Nevertheless, the Re City Equitable case is important as the first comprehensive case and for the general comments focusing on the care and skill of company directors made by the first instance court. Unlike the 1911 Re Brazilian Rubber Plantations and Estates Ltd decision, in the Re City Equitable case, subjective and objective tests were presented together, but the effectiveness was certainly questionable.

However, it should be noted that Romer J also referred to the decision of Neville J in the Re Brazilian Rubber Plantations and Estates Ltd case. Neville J's decision also mentioned the term reasonable care. This term can be considered an objective criterion quoted by Romer J. On the other hand, Romer J's explanation about reasonable directors can be called an ordinary man or director and has been termed as the "charming standard of madness." Because, in the decision, Romer J clearly accepted the basic test of Neville J in the Re Brazilian Rubber Plantations and Estates Ltd case. We can see this from page 428 of the decision. The required standard of reasonable care was measured by the care that an ordinary man could be expected to take in managing their own affairs. Romer J's above-mentioned suggestions were expressed as "in addition" to Neville J's basic objective test.

The first explanation was clearly subjective, stating that "a director need not exhibit a greater degree of skill than may reasonably be expected from a person of their knowledge and experience in the discharge of their duties." However, the next sentence of the decision explicitly defines the subjective test with the words "For instance, a director of a life insurance company does not guarantee that they possess the skill of an actuary or a physician."

Such statements show that the subjective test on skill did not allow the standard of care to drop to the level of a halfwit. According to Andrew Hicks, Romer J was establishing a two-tiered standard: first, the minimum and irreducible objective standard of reasonable care that an ordinary person would exercise in their own affairs, and second, the subjective test that relieves the director unless they have very special expertise. Therefore, it can be said that Romer J's subjective test was not intended to lower the standard of care below that of a reasonable ordinary businessman. At that time, there was no approach he was trying to establish. Therefore, even though he did not create a clear path, his explanations in Re City Equitable opened a new dimension for directors' duties of care and skill through dual evaluation. At this point, it can be clearly seen that the approach of some sections of the 1986 Insolvency Act, regarding the duties of care and skill of directors within the scope of subjective and objective norms, is almost the same as Romer J's approach in the Re City Equitable decision.

Relationship Between the Insolvency Act 1986 and Re City Equitable

As mentioned in the Re City Equitable case, the company liquidator sought a decision requiring other directors to contribute to the company's assets due to mismanagement committed by the directors. This was not available to proceed under Section 212 of the Insolvency Act 1986. Section 212 of the Insolvency Act 1986 sets out the legal concept of mismanagement and personally holds a director of a company liable to pay the amount of loss resulting from mismanagement to the company. In this context, proceeding under Section 212 of the Insolvency Act 1986 for mismanagement could have been another option. According to Romer J, the other directors acted honestly, and no allegation of fraud was made against any defendant other than Bevan. Years ago, it is clear that Romer J identified responsible and non-responsible directors.

As in Re City Equitable, creditors pressuring liquidators to take action should be prepared to indemnify the liquidator for costs if there may not be sufficient assets to support the case. Similar considerations apply to liquidator actions under Section 214 of the Insolvency Act 1986, known as wrongful trading, which may also involve negligence by directors. Liquidators may have felt compelled to seek indemnities from creditors before commencing wrongful trading claims. Wrongful trading was a great hope of the Cork Committee, recognizing that more was needed to capture irresponsible director behavior than the existing fraudulent trading provisions. Section 214 of the Insolvency Act 1986 contains the main features of these recommendations, but a claim under Section 214 of the Insolvency Act 1986 covers only a limited range of negligent managerial behaviors. When a company's insolvency appears inevitable, the failure of directors to take appropriate steps to protect creditors may be considered more than just negligence. In short, under Section 214 of the Insolvency Act 1986, a liquidator cannot occupy incompetence or mismanagement that led the company to the brink of insolvency.

Negligence and serious mismanagement can cause real economic harm to the company's business, and particularly in insolvency, can certainly affect liquidators. In this context, shareholders may face directors or controlling shareholders who refuse to take action against negligent directors.

Before the 2006 Companies Act, shareholders could apply to the lower courts to compel a liquidator to sue under Section 212 of the Insolvency Act. However, the problem was that this section could only be applied in cases of willful neglect by directors. In short, in terms of legal remedies, only corporate shareholders are likely to overcome the discussed practical, procedural, and financial barriers, such as the need to obtain sufficient shareholder support to support action, especially under company law.

In the 1986 Insolvency Act, another issue can be evaluated in terms of Romer J's decision. As mentioned earlier, Romer J's decision had both subjective and objective norms in terms of duties of care and skill. In the 1992 Norman v Theodore Goddard decision, cited by the defendants and accepted by Lord Hoffmann, the dual test is correctly set out in Section 214(4) of the Insolvency Act 1986; this section states that directors will be held accountable both (a) for the general knowledge, skill, and experience reasonably expected of a person performing the functions they performed with respect to the company, and (b) for the general knowledge, skill, and experience they actually possess. In short, it is clear that Theodore Goddard advocated a dual standard consisting of an irreducible objective minimum that could be enhanced but not reduced by the specialized knowledge of the individual director.

The Indirect Effects of Romer J's Approach on the Companies Act 2006

The test mentioned above by Lord Hoffmann was also confirmed in the 1994 Re D’Jan of London Ltd case, and Lord Hoffmann almost emphasized the same thing: "In my opinion, the duty of care owed by a director at common law is correctly stated in Section 214(4) of the Insolvency Act 1986."

Lord Hoffmann's approach is now codified in Section 174 of the Companies Act 2006, which approximately reproduces Section 214(4) of the Insolvency Act 1986 in the same terms. According to this section, an objective/subjective standard is declared; subparagraph (a) encompasses the irreducible objective part, and subparagraph (b) encompasses the subjective part that can potentially increase liability. Clearly, Romer J's method of examining both norms can be easily seen here.

Additionally, despite its wording, Section 174 of the Companies Act 2006 is widely accepted as codifying a single integrated duty of care, skill, and diligence rather than three separate duties. According to Carsten Gerner-Beuerle and Michael Anderson Schillig, this development aligns with the dominant majority of pre-2006 case law applying a single standard.

Section 174(a) of the Companies Act 2006 also sets the objective norm. Generally, the duties of board members can be divided along functional lines. First, in companies with a unitary board system, we can distinguish between those who make business decisions and those who oversee the directors, i.e., between executive and non-executive directors. Additionally, the responsibilities of executive directors are often divided to reflect the organizational structure of the company. As recalled, this issue was a firm dilemma in the late twentieth century.

The modern corporate governance framework is based on the principle of "collective responsibility." The reference in Section 174 of the Companies Act 2006 to the functions performed by a director allows for differentiation in the standard of care, but may not exempt directors from the requirement to act with ordinary care and possess average knowledge in economic matters when reviewing and approving annual accounts.

Directors were acquitted due to a clause in the company's articles that only made them liable for company losses if the losses occurred due to "willful neglect or default" (such a provision is now illegal under Section 232 of the Companies Act 2006). However, the importance of the case lies in Romer J's careful determination of what he saw as the fundamental features of the duties of care and skill of company directors. Romer J stated that directors should act honestly and in accordance with the standards reasonably expected of persons with their knowledge and experience, attend board meetings as far as they reasonably could, and delegate responsibilities to other company officials when there was no reason to suspect mismanagement. These repeated references to acting "reasonably" marked a dramatic shift from the very low and entirely subjective standards previously expected of directors in earlier cases and set the stage for the reform of the law relating to directors' duties.

The Companies Act 2006 and the Current State

Finally, in light of current developments, it can be noted that the codification of directors' general duties still needs to be examined. Although the Companies Act 2006 has taken a step regarding directors' duties of care and skill, the principle of equitable and common law principles applying equally to directors' general duties in legal interpretation needs to be emphasized.

However, Section 170(4) of the Companies Act 2006 lays the groundwork for future flexibility, as company law borrows various equitable and common law rules applied to directors.

Conclusion

Today, both the Companies Act 2006 Section 174 and the Insolvency Act 1986 Section 214 use both subjective and objective approaches to evaluate directors' duties of care and skill. It can be noted that Romer J, in the Re City Equitable decision, stated that both subjective and objective tests should be examined in the event of insolvency. In the past, in some cases, only the objective test may have been considered sufficient, while in others, only the subjective test may have been effective. However, in the Re City Equitable decision, it was clearly seen that a single test might not be effective in some cases. In fact, Romer J's difficulty was an effort to approach the problem from a new perspective. The Re City Equitable case is important as the first comprehensive case for the general comments focusing on the care and skill of company directors. Romer J took the issue of "reasonable care" from the Re Brazilian Rubber Plantations and Estates Ltd decision; in the Re City Equitable case, subjective and objective tests were presented together, but the effectiveness was certainly questionable.

In Re City Equitable, it can also be said that "the standards reasonably expected of persons with their knowledge and experience" form the basis for some very traditional and subjective approaches, but as explained above, this was actually a standard in the modern corporate governance context with Romer J's second explanation, and it was a fundamental determination for the issue of reasonable care, although not clear. Unlike the Lagunas Nitrate Co. v. Lagunas Syndicate [1899] 2 Ch 392 decision, the approach in Re City Equitable was not only subjective.

Before Section 212 of the Insolvency Act 1986, years ago, it was clear that Romer J identified responsible and non-responsible directors, showing a need to see these differences and determine differences through the dual objective/subjective test. Considering the difference between executive and non-executive directors in modernized corporate governance norms, this can be evaluated as the foundations of this difference. Additionally, in the past, shareholders could apply to the lower courts to compel a liquidator to sue under Section 212 of the Insolvency Act. However, it should be noted that there was the issue of applying this section only in cases of willful neglect or default by directors. This issue was also brought comprehensively by Romer J for the first time in the Re City Equitable decision.

On the other hand, the impact of the Norman v Theodore Goddard decision may not have been seen by some academics. However, in that decision, the concept containing the irreducible objective part and subsection was almost the same as Romer J's approach. Therefore, in the Companies Act 2006, we can see the same fundamental effort of Romer J more internalized.

In addition, in light of current developments, it can be noted that the codification of directors' general duties still needs to be developed. Even the Companies Act 2006, which has taken a step, especially in terms of directors' duties of care and skill, needs to emphasize the principle of equitable and common law principles applying equally to directors' general duties in legal interpretation.

The issue is whether to create a definitive codification of directors' duties of care and skill, and it is clear that there is still a need to make progress. On the other hand, Section 170(4) of the Companies Act 2006 indeed provides flexibility as it borrows various equitable and common law rules applied to directors in company law. This makes it possible for duties to evolve, change, and be added.

References

• The Law Commission and The Scottish Law Commission (Law Com No 261) (Scot Law Com No 173) Company Directors: Regulating Conflicts of Interests and Formulating A Statement of Duties September 1999

• Nicholas Bourne AM ‘Directors- Duty of Care and Skill’ Company Law (2004) 25 Bus. L. Rev. 217

• Davies P. L. (Paul Lyndon), Sarah Worthington, Eva Micheler, and Gower L. C. B. (Laurence Cecil Bartlett) (2016) Gower's Principles of Modern Company Law. Tenth / Paul L. Davies QC (hon) FBA, Sarah Worthington QC (hon) FBA; with a contribution from Dr. Eva Micheler. ed. London: Thomson Reuters (Professional) UK Ltd trading as Sweet & Maxwell

• The Association of International Accountants (AIA) ‘A Quick Look at… ‘City Equitable Fire Insurance Co Ltd [1925] CH407’ Link accessed 12 January 2020

• MJ Trebilcock ‘The Liability of Directors for Negligence’[1969] The Modern Law Review 32 (5) Link accessed 12 January 2020

• Hicks Andrew [1994] ‘Directors' Liability for Management Errors’ Law Quarterly Review 110: 390 Link accessed 16 January 2020

• Finch Vanessa [1992] "Company Directors: Who Cares about Skill and Care?" The Modern Law Review 55 (2)

• Gerner-Beuerle Carsten and Michael Schillig [2019] Comparative Company Law (First ed.) Oxford: Oxford University Press

• Dignam Alan J. [2011] ‘Hicks & Goo's Cases and Materials on Company Law’ (7th / Alan Dignam ed.) Oxford: Oxford University Press

• Worthington Sarah and L. S. Sealy [2016] Sealy and Worthington's Text Cases and Materials in Company Law (Eleventh / Sarah Worthington QC (Hon) FBA. ed.) Oxford United Kingdom: Oxford University Press

• Keay AR [2014] ‘Wrongful Trading: Problems and Proposals’ Northern Ireland Legal Quarterly 65 (1). 63 - 79 (17)

• Sheikh Saleem [2008] A Guide to the Companies Act 2006 (2006th ed.) London: Routledge-Cavendish 383 and 384

Cases

• Re City Equitable Fire Insurance Co [1925] Ch. 407

• Re D’Jan of London Ltd [1994] 1 BCLC 56

• Norman V Theodore Goddard [1992] B.C.C. 14

• Lagunas Nitrate Co v Lagunas Syndicate [1899] 2 Ch 392

• Re Denham & Co (1884) 25 Ch D 752

• Re National Bank of Wales Ltd. [1899] 2 Ch. 629 672

Relevant Laws

• Insolvency Act 1986

• Companies Act 2006