Reading room

Get in touch with our corporate lawyers in the UK and call us on 0330 107 0106 to arrange a free no-obligation call or request a free quote.

Directors powers stem from the Companies Act 2006 (Act) and from the Articles of Association of the company (Articles). The members may seek to limit those powers, in particular by reserving certain acts to a resolution by members. Whilst this is an efficient method of ensuring the members retain strategic control over decision-making, this method has its limitations which cannot be contracted out.

Under s.40 of the Act, in favour of a person dealing with the company in good faith the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the Articles.

In practice, this means that even if the Articles prohibit certain transactions without a resolution of shareholders (such as large contracts or taking on credit) the company will nonetheless be bound by the terms of that contract. This is so even though the directors have acted outside of their authority as stipulated in the Articles and clearly in breach of both, the Articles, and their obligations under s.171 of the Act, namely to act in accordance with the company’s Articles and exercise their powers only for the purposes for which they were conferred.

The Act goes even further than this, stating at s.40(2)(b) that a third party dealing with the company:

• is not bound to enquiry as to any limitation of the powers of the directors;
• is presumed to have acted in good faith unless contrary is proved;
• is not to be regarded as acting in bad faith by reason only of his knowing that an act of the directors is in breach of the Articles.

As such a counterparty can be fully aware that the directors are acting outside of their authority when entering into contract and still hold the company to the terms of that contract, bad faith being difficult to prove and knowledge of lack of authority being specifically excluded from the definition of bad faith.

This falls squarely against not only the common practice in many overseas jurisdictions (and thus may come as somewhat of a shock to overseas businesses expanding to the UK) but is also a clear deviation from what one might expect under the general law of agency, where an agent (such as a director) cannot normally bind a principal (the company) if they act beyond their actual authority, the law of agency being overridden by statute.

The protection enjoyed by third parties under s.40 of the Act does however not expand to those who are directors or persons connected with the director. Indeed, s.41 of the Act introduces an exception to the general rule under s.40 of the Act, stating that if the parties to the transaction include a director or a person connected with such director, the transaction will be voidable by the company. S.40 of the Act aims to protect the company (and ultimately, its members) from insider abuse or self-dealing, where directors act in their own interests rather than the interests of the company. However the transaction will cease to be voidable if any of the exceptions in s.41(4) of the Act apply, mainly centred around restitution.

It should be noted however that whilst unconnected third parties will enjoy the protection of s.40 of the Act, so long as they do not trade in bad faith, this does not mean that there are no consequences to the directors. Indeed, under s.40(5) of the Act the directors’ liability to the company for breaches of their authority is not waived or restricted and under s.41(3) of the Act the directors are liable to compensate the company for transactions with themselves or connected parties. Further s.40(4) of the Act does not prevent any member of the company to bring proceedings for injunctive relief to stop the transaction taking place, if it acts quickly.

The policy underpinning the UK’s approach is clear. The law is designed to facilitate trade and protect commercial third parties. Without these rules, every party dealing with a company would need to check the Articles and verify that the relevant directors were acting within their powers.

That level of diligence would be burdensome, impractical, and costly, especially in day-to-day commercial transactions. It would also undermine confidence in doing business with companies. By ensuring that contracts signed by directors are enforceable, the law supports fluidity in commerce.

From a governance perspective, this framework recognises that any internal abuse of power by a director is best dealt with between the company and the director, not at the expense of an innocent third party.

Notwithstanding this policy there are steps members of the companies can take in order to protect their position and strategic decision making:

• Reserving strategic decisions to members – as reasoned, this will not mean the contract will be voidable against and unconnected third party, this will nonetheless offer a clear route to sue the director for breach of Articles.
• Use Directors’ Service Agreements – contractual agreement with directors should further stipulate that the directors must act within their authority or be accountable in contract (as well as under statute) to the company. The company can move to terminate the directors for breach (an inalienable right of members acting by majority under the Act) and sue the director for breach of contract.
• Dual authorisation requirements – As a practical safeguard, companies can implement internal procedures requiring dual signatories for certain transactions, especially those over a specified value. Whilst this won’t affect a third party’s ability to enforce the contract, it may reduce the likelihood of unilateral action by a rogue director.
• Insurance – Companies may wish to consider Directors and Officers insurance to cover potential liabilities arising from unauthorised acts.
• Act quickly – if the members are aware of the intended transaction being outside of the powers conferred by the directors, that member can seek injunctive relief before the transaction takes place.

Understanding UK company law and managing risks is critical to overseas businesses looking to set up an establishment in the UK.

For guidance on directors’ powers, internal governance procedures, or assistance with setting up a business in the UK, you may contact IMD Corporate. They are available to assist with corporate legal matters and risk management.

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.

To find out more about our services, visit Corporate Solutions section of our website.

Call us now to discuss your case 0330 107 0106 or email us at business@imd.co.uk.