2.6.5 Duty of care and distinction between executives and NEDs

We start with the duty of care, which in the past has always tended to be of a very low standard. A decision of 1925 re City Equitable Fire Insurance Co. describes this.1 In that case, where the chairman was held liable for fraud, a non-executive director was not held liable for having transgressed the duty of care, because he had no serious role. There was no objective standard for expected care and there was a highly subjective duty: "a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from someone of his knowledge and experience". An earlier famous example was the Marquess of Bute, who was appointed president of a bank at the age of six months and attended only one meeting of the board in his whole life. He was not held liable.2

Dorchester Finance was a money lending company with three directors, all of whom had accountancy experience. For the relevant period only Stebbing, the executive director, was actively involved in the company's affairs. There were no board meetings. Harris and Lewis, the two non-executive directors, never looked at Dorchester's books or accounts. They admitted to signing blank cheques, which enabled Stebbing to apply funds, illegally, as he pleased. The non-executive directors relied on the argument that their duties were to a lower standard than applied for executives, and that accordingly they had no duties to perform.

The court held that "A director in carrying out his duties: (i) was required to exhibit in the performance of his duties such a degree of skill as may reasonably be expected from a person with his knowledge and experience, (ii) had, in the performance of his duties, to take such care as an ordinary man might be expected to take on his own behalf, and (iii) must exercise any power vested in him in good faith and in the intererts of the company." No distinction could be drawn between executive and non-executive directors.

On this basis, all three directors were found to have been negligent.

Bingham, a partner at Theodore Goddard, a London firm of solicitors, specialising in tax and trust work, was involved in fraudulent dealings with trust funds, including a Jersey settlement of which Mrs Norman was the settlor and tenant for life. The asset of the trust was the share capital of LBI, a company holding property and cash. Bingham arranged for Somerville, an employee of Theodore Goddard, to be made the sole director of LBI and Somerville then appointed a third party, Quirk, as another director. Quirk took on responsibility for the day-today business and cheque book. Bingham persuaded Quirk to deposit LBI's cash with Gibbon in order to obtain offshore tax advantages. Bingham was "the picture of the respectable member of a very eminent firm of city solicitors". He assured Quirk that depositing the money with Gibbon was more profitable than putting it elsewhere, the money would be available if needed, and that Gibbon was under the control of Theodore Goddard and thus safe. However, Gibbon was in fact owned by Bingham, who stole the funds.

The court held that on the facts "a director…need not exhibit a greater degree of skill than may reasonably be expected from a person undertaking [his particular] duties", but "in considering what a director ought reasonably to have known or inferred, one should also take into account the knowledge, skill and experience which he actually had in addition to that which a person carrying out his functions should be expected to have". Quirk did not breach his duty by relying on the information given to him by Bingham and acted reasonably in not investigating further, given Bingham's positron.

Griffiths, Conway and Wassall were directors of Westmid Packaging Services. Griffiths was a "much-respected businessman and a pillar of the community" the controlling force behind the company. Conway and Wassall were "treated more like employees than directors". They did not read Westmid's financial statements or accounts and therefore did not appreciate that Griffiths was using Westmid's assets for the purposes of other companies in his group or that he allowed Westmid to continue trading even past the time that he must have known that the company was insolvent.

The Court of Appeal noted that:

"...the collegiate or collective responsibility of the board of directors of a company is of fundamental importance to corporate governance under English company law. That... must however be based on individual responsibility. Each individual director owes duties to the company to inform himself about its affairs and to join with his co-directors in supervising and controlling them.

A proper degree of delegation and division of responsibility is of course permissible, and often necessary, but not total abrogation of responsibility. A board of directors must not permit one individual to dominate them and use them...".

Swan was chairman and CEO of Finelist pk. An experienced accountant, North, was a nonexecutive director and deputy chairman, as well as chairman of the audit and remuneration committees. Finelist practised cheque kiting, taking advantage of the time taken for a cheque to clear to obtain a fictional increase in the balance of the payee's account before the cheque is cleared giving a rosier picture of the annual accounts.

Swan was rarely asked to sign cheques but on one occasion, without asking any questions, he signed four cheques that as a result of their size and matching amounts "called out for comment and question". These cheques crossed between the two subsidiaries thereby creating artificial credit for the group. North was informed of various accounting and financial irregularities by a senior manager. Instead of investigating, he had a short meeting with Swan and the finance director, believed and accepted the finance director's explanation, and did no more. As a result of the cheque kiting, an indebtedness statement in a circular to shareholders showed materially inaccurate figures and the group breached its banking covenants.

Swan "was a businessman with obvious flair and drive in relation to operational matters, but he was not a person likely to pay attention to financial or accountancy technicalities or other matters of detail which he did not regard as having an obvious impact on the profit or loss of the group". He was held not to have had actual knowledge of the cheque kiting but he ought to have known as a result of the unusual cheques he had been asked to sign, which should have prompted him to make enquiries. However, on the statement of indebtedness in the circular, he was entitled to have lelt this to the finance team.

North's response to the allegations by the senior manager was held by the Court to have been "wholly inappropriate, unsatisfactory and inadequate". He had failed to show the "decisive, courageous and independent action" required of a non-executive director.

Neither Swan nor North were found to have acted fraudulently or dishonestly. Disqualification orders were made against both directors. Swan should have asked further questions as CEO. North should have asked further questions, because he had extra financial expertise. A nonexecutive director must be prepared to rock the boat.

Equitable Life was an unlimited liability society whose members were with-profits policyholders. Until June 1988 policies were provided, in a high number of cases, with guaranteed annuity rates permitting the policyholder to receive an annuity at a guaranteed rate on retirement. Over several years this rate exceeded the normal annuity rate prevailing on other policies at the retirement date, and in the interests of faimess, the board adopted a differential terminal bonus policy, which adjusted the bonuses paid under their policies to equalise annuities payable under policies where the guaranteed rate was chosen and other policies where it was not. Complaints were made and a test case was brought to determine whether Equitable had the right to declare differential bonuses. Equitable lost the case and issued proceedings for negligence against its former directors.

Equitable alleged that the directors were negligent in (i) failing to take legal advice as to the validity of the differential terminal bonus policy before awarding the differential bonuses each year, and (ii) after the problem was known and legal advice had been sought and given, failing to reduce bonuses and ensure that existing and prospective policyholders were fully aware of the potential costs to the company should the test case be lost. It also alleged use by the directors of their discretion for improper purpose.

The non-executive directors sought summary judgment, excusing them from liability, arguing that they had relied on the executive directors. The court was not sympathetic, concluding that the duty owed by a non-executive director does not differ from that owed by an executive director saying "It is plainly arguable ... that a company may reasonably at least look to nonexecutive directors for independence of judgment and supervision of the executive management." The application for summary judgment was refused. The trial began in 2005, but after the case went badly for Equitable — there were difficulties in proving breach of duty and causal links between alleged breach and the damage claim — it agreed to drop the case and pay the legal expenses of the directors.

The case was a much discussed case by directors and lawyers, because of the huge amounts involved and because many directors and lawyers held policies with Equitable Life. In the same case the judge had previously given a summary judgment in favour of the auditors, dismissing a claim against them. A week before the hearing of the directors, his judgment in the auditors' case was overruled by the Court of Appeal. He was therefore more cautious and less robust about dismissing the claim against the directors. In the subsequent trial the plaintiffs abandoned their claim against the directors after presenting it, but before the defence was presented, i.e. the plaintiffs accepted they had no claim. The claim against the auditors was also lost. Nevertheless, the case had made NEDs nervous.