Lessons learned from Carillion for non-executive directors
Insight
We had the privilege of welcoming Andrew Thompson KC from Erskine Chambers, who represented the non-executive directors in the high-profile Carillion case, to our recent webinar focused on the role and duties of non-executive directors (NEDs). Andrew was joined by Eleanor Rowswell (Partner and co-lead of Farrer & Co’s senior executive unit) and David Fletcher (senior insolvency Partner at Farrer & Co). We are very grateful for Andrew’s contribution to the webinar and to the preparation of this summary.
This is a summary of the issues that were discussed in the webinar from both a company’s and NED’s perspective.
1. Legal framework
Companies and board members should be aware that there is a huge range of roles undertaken by a NED, from acting as a sounding board to a start-up business, to sitting on the board of a high profile listed company. In each case, the primary point of reference is the Companies Act 2006 (the Companies Act) and the duties codified under it. A director must be able to show visibly that they are discharging those duties. For directors of a premium listed company, the corporate governance code (the Code) will also be relevant (and has just been updated[1]). Whilst not legally binding, the Code conditions what is expected, in practice, to show compliance with the relevant duties.
2. Practical guidance
A. When joining a company
Letters of appointment
Although strictly speaking not necessary, it is common practice for NEDs to enter into letters of appointment to formalise their appointment. As these will usually be contractual, both the director and company should be aware that this could provide an additional limb to a claim against directors alongside a claim for breach of duty under the Companies Act (although cases of such breach of contract claims have been rare).
In a premium listed company context, letters of appointment are largely driven by and incorporate the principles of the Code, meaning that there is limited scope for negotiation of the terms. That said, it is still important for companies to consider the contents of the exact terms of a NED’s appointment and the NEDs should read these letters very carefully, and take advice on them, to ensure they are clear on their obligations, the role they are being asked to perform and the support they will need from the company to perform that role. Those terms are likely to define their role and the role a director undertakes determines in part the knowledge and skill to be expected of them in complying with their duty of reasonable care, skill and diligence under section 174 of the Companies Act 2006.
In a private company context there is more flexibility to negotiate these terms, and a NED should do so to ensure their role is defined appropriately and not too widely. They cannot contract out of their duties under the Companies Act, but they can define their role to limit their exposure to claims under section 174 of the Companies Act. If, instead, they agree to take on a role which is unrealistic for them given their skills, experience or the time they can commit, then they may increase their exposure to a claim under section 174. This is because for the purposes of the duty under that section they will still be expected to display the skill and knowledge to be expected of someone in that role, despite that role being unrealistic for them. If possible, the limits of the role should also be adapted to the business environment in which the company operates. There are however limits to the ability of a NED to define their role in a narrow fashion. There is an (ill-defined) “irreducible minimum” requirement as regards the role of a NED. Therefore, a NED cannot, for example, contract out of a requirement to attend board meetings or read board papers/the accounts. These will be expected of a NED regardless of any contractual terms to the contrary.
Director’s indemnities
A key priority for a NED looking to join a board is to obtain indemnification from the company for their actions in the role. The Companies Act prohibits a company from granting an indemnity for any liability in connection with any “negligence, default, breach of duty or breach of trust” by a director in relation to the company. However, companies can, subject to certain conditions, indemnify its directors for third party claims (for example shareholders).
It is essential to ensure there is a provision in the company’s articles of association allowing such an indemnity to be granted. However, it is equally important for a standalone indemnity to be included either in the letter of appointment or in a director’s deed of indemnity. It is not advisable to rely solely on the indemnity within the company’s articles itself because the articles are not directly enforceable by a director (and so if there is only an indemnity provision in the articles, one would have to argue that it had impliedly been incorporated into a contract between the director and the company).
Directors’ and officers’ (D&O) insurance
D&O insurance is an exception to the Companies Act restriction on director’s indemnification. D&O will:
- (Subject to the terms of the exact policy) enable the director to look to the insurer for a financial contribution towards the cost of any claims that a company (or a third party) may bring against a director, and
- Be issued from a third-party insurer which, subject to the premium on the policy being paid, mitigates against the risk of the company not having the financial resources to meet its obligations under a director’s deed of indemnity. An indemnity from the company often proves valueless just when claims against the director are most likely, ie when the company fails.
A D&O policy is therefore very important if it is available, particularly if the NED appointment is to a large listed company or a company operating in a high risk industry.
Accordingly, reviewing the D&O insurance policy with the in-house legal team or other professional is a critical piece of due diligence for an incoming NED to undertake. Ideally, there would be a separate policy for NEDs (or at least a separate ‘pot’ of cover reserved for them and not shared with others). It is also vital to ensure that the full range of possible liabilities and expenses are covered (including directors’ disqualification claims and regulatory investigations and not just claims by the company or shareholders for financial compensation).
The company
Above all, a NED should consider the company’s business when they are offered a role. Careful consideration should be given to, for example, high profile, low margin, complex businesses because the terms of any letter of appointment will be of limited value to protect against personal risk and reputation if the company’s underlying operations are high-risk. Likewise, even very good D&O insurance is not a complete protection. Large corporate failures can drain even the largest D&O pot very quickly (because there will be many people calling on it, for a number of different purposes: for example, regulatory investigations, officeholder claims and disqualification proceedings, potentially in more than one jurisdiction). Further, such failures tend to engender investigations and claims, even against directors who have in fact discharged their duties well, sometimes under political pressure, and that is very stressful even if there is ultimately no liability.
B. Discharging the duties of a NED
The role of a NED is inherently challenging because they have to:
- Have oversight of the company’s entire business (which may be large, diverse and complex),
- Conduct the role with a limited time commitment and with usually limited resources, and
- Rely on others to select and deliver the information being presented to them.
It is therefore important to break the role down to determine what level of support a company can give to their NEDs. Where the exposures for NEDs tend to lurk are:
Supervision
The NEDs’ role in supervising management and the business falls broadly into two parts: supervising the company’s systems and processes, and supervising specific decisions. It is usually more realistic to expect NEDs to play an effective part in establishing and reviewing good systems and processes for the review of decision-making and the preparation of accurate accounts than it is to expect them to be able to effectively scrutinise individual decisions, particularly in a complex and large business.
Regarding scrutiny of individual decisions, hindsight can often be deployed unfairly against NEDs when it turns out that specific decisions were not in fact taken properly by management or specific aspects of the business were mismanaged and there was a failure to detect that. The reality is often that it is impossible for NEDs to identify such problems with the limited information provided to them and the limited scrutiny which they can exercise at board meetings. However, with hindsight, it may often be said (often unfairly) that NEDs could have asked more questions or demanded more information in order to identify mismanagement. For example, in the Carillion case the NEDs were criticised (in Andrew Thompson KC’s view unfairly) for failing to realise that several large construction contracts were being accounted for inaccurately by reference to the very limited information reported to them in relation to those contracts at board meetings. In reality, it was not possible to detect from that information that there was anything wrong with the accounting for those complex contracts.
How should NEDs try to deal with this problem? First, NEDs should make sure that they carry out those aspects of their supervisory role which are realistic, such as supervising systems and controls, genuinely very well. NEDs should also be visibly diligent in attempting to discharge the less feasible aspects of their supervisory role by making sure that they diligently read the information which they are provided and ask perceptive questions in relation to it. That will show that they have done all they reasonably could to oversee the company’s management, even if that has not succeeded in hindsight.
NEDs should also take steps to insist on appropriate practices from management in providing them with information. They should insist on (1) being given only carefully selected and genuinely relevant information and (2) being provided with commentary explaining the relevance of the information and what they should be focusing on in reading it (and not just the raw information).
Strategy
The other aspect of the NEDs’ role, in addition to supervision, is strategy. NEDs can realistically make a very significant contribution to strategic decisions (such as acquisitions, joint ventures, withdrawal from particular markets etc) and they are also less likely to be exposed to liability or criticism with hindsight as a result. First, it is much easier for NEDs to make sure that they have all the necessary information relevant to a particular strategic decision than it is in relation to general reporting to the board: they will understand the decision to be taken and can identify the information that they need and can insist on getting it. Second, such decisions almost inevitably involve a large element of business judgement, which to some extent will insulate them from criticism and liability after the event.
Record keeping
Documenting the decisions of the board on strategy and supervision is important to ensure there is a contemporaneous record of what has been decided. This will be through board minutes, which will provide a summary of the decisions being made and which will be prepared by the company secretary or chair of the board. However, board minutes can be problematic. They cannot be verbatim records of what was said, and sometimes this is exploited by those who wish to criticise or make claims against directors contending (often years later) that if there is no record of questions being asked or information provided, it is to be inferred that they were not asked and that information was not provided. That is often unfair, but unavoidable. Therefore, directors should also consider keeping a record of how they have contributed to the board discussions at an individual level, particularly in relation to areas of potential contention.
Delegation
It is critical and inherent in a NED’s role to be able to delegate, and this should be done by reference to a director’s section 174 duty under the Companies Act (the duty to exercise ‘reasonable care, skill and diligence’). A director must comply with that duty in deciding to delegate, for example by exercising reasonable care, skill and diligence in ensuring that the person to whom the task is delegated is reasonably competent and also honest. A director will also continue to have a duty to exercise reasonable care, skill and diligence in supervising those who are undertaking the delegated roles. No parts of a director’s role can simply be passed to another. Moreover, the terms on which that delegation have been set should be clearly documented.
Financial distress
Where a company is starting to experience financial difficulties there will be a need for the board and potentially (in some circumstances) individual directors to seek appropriate professional advice to ensure that they are acting appropriately in accordance with their duties.
The Supreme Court recently held that when a company is insolvent or bordering on insolvency, or it is likely (more probable than not) that the company will go into insolvent liquidation or administration, the company’s board will need to start to take account of not just the interests of shareholders but also the interests of creditors (commonly referred to as the “creditor duty”). As the company’s financial position worsens the interests of creditors will become more important. Once insolvent liquidation or administration has become inevitable, the interests of creditors will become paramount and the directors should no longer take account of shareholders’ interests.
The majority of the Court held that in assessing whether the creditor duty has arisen the board’s understanding of the company’s financial position will be assessed on both a subjective and objective basis. This is so that if a director did not realise that the company’s position was in fact such as to trigger the creditor duty, that will not be sufficient to protect that director if they ought to have known that this was the case.
The details of the “creditor duty” are still evolving and will be the subject of future court decisions. However, the general backdrop of the need for a board to consider the interests of creditors when a company is in financial difficulties and the various statutory and common law duties are not new, and we have significant experience within the firm advising boards and individual directors. In these situations it is critical to obtain appropriate advice as soon as these issues arise.
3. Summing up
In summary, four important practical lessons for NEDs to take home are:
- Choose your company and your NED candidates carefully and engage third parties to conduct due diligence on the opportunities and risks,
- Try to define (or where that is not feasible, at least understand) the practical role which is expected of the NED in a realistic way on appointment, specific to the company and the appointment,
- Make sure there is appropriate D&O insurance in place, tailored to the NEDs’ needs and consider whether there should be a reserve or escrow established to settle policy premiums for future years, and
- Perform the more feasible aspects of the role well, ie strategy, record keeping, delegation, systems and controls). In respect of the more challenging aspects, ie supervision of specific decisions, NEDs should visibly demonstrate diligence, showing that they have done all they reasonably could in the particular circumstances (even if, with hindsight, that has not succeeded), with the company’s infrastructure and systems supporting them to be effective in their roles.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, February 2024
