Companies (Audit, Investigations and Community Enterprise) Bill [Lords]

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Jacqui Smith: I beg to move, That the clause be read a Second time.The Chairman: With this it will be convenient to discuss the following:

Government amendment No. 2.

Government new clause 2—Funding of director's expenditure on defending proceedings.

Government amendment No. 3.

Jacqui Smith: As I said earlier, the Bill aims to ensure that we put in place the legal framework to

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ensure effective corporate governance, financial reporting and audit. The second part of the Bill aims to put in place the important ability, through the new vehicle of community interest companies, to develop the great potential that social enterprise has to offer our economy and communities. Today, we are focusing on the first part of the Bill.

In the new clauses, we focus on the issue of directors and their liability in particular. Directors play an important part in corporate Britain, being responsible for the performance of Britain's 1.8 million companies, which account for about 80 per cent. of economic activity measured by turnover and provide some 60 per cent. of employment. Their performance is therefore a crucial factor in improving British productivity and competitiveness, providing the jobs that are so crucial as well as the prosperity that comes from the effective running of corporate Britain, and ensuring the trust that we all need to have in our companies as employees, suppliers or customers.

The new clauses also consider the difficult issue of directors' liability. The Government published a consultative document in December last year, which helped to stimulate a vigorous debate on that issue. That is not surprising, because, as I said, directors play such an important role in Britain's business life. At the same time, because of that crucial role, discussions about issues relating to directors can all too often generate more heat than light. That is why it is so important that in making these recommendations in our proposals we have been able to build on not only our recent consultation, but the recommendations of the independent company law review and the review carried out by Sir Derek Higgs at the request of the Chancellor and my right hon. Friend the Secretary of State to look into the issue and role of non-executive directors, and in particular their effectiveness and how we can ensure a pool of sufficient high quality.

When we consider the issue of directors, there is substantial agreement on the objectives that we are trying to achieve: first, a diverse pool of high-quality individuals willing to assume the important role of company director; secondly, that those directors are willing to take informed and rational risks in the direction of the companies for which they have responsibility; and thirdly, the maintenance of a high standard of care, skill and diligence for company directors by ensuring that companies can hold negligent directors to account.

That final point is important. We need people who are willing to become directors, but that is not enough in itself. We need directors who are conscientious, well informed and honest. It is clearly important that a director who acts in breach of his duties to the company can be held to account by it. That is why the prohibition on companies exempting directors from, or indemnifying them against, liability was introduced as long ago as 1928. That is the issue that the new clauses seek to address.

In recent years, the courts have imposed a much more demanding standard of care, skill and diligence on directors. That is a welcome development, which

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we would certainly not wish to undermine. It is absolutely right that directors, in fulfilling their crucial role in corporate Britain, take seriously the responsibility to show the care, skill and diligence that we would expect of them. It is also right that the courts take that responsibility seriously.

Our consultation has, however, provided strong anecdotal evidence that concerns about liability are affecting the recruitment and behaviour of directors. Ironically, that is particularly true of those companies that most need strong directors, such as struggling companies and companies in sectors such as financial services. There appear to be two particular concerns: exposure to third party liabilities, particularly in the United States, and the cost of lengthy court proceedings. Those concerns are widely shared.

Two thirds of the responses to the consultation accepted, for example, that issues relating to potential liability might affect the recruitment of able non-executive directors. The Institute of Directors suggested that there is a particular problem in sectors such as financial services and that concerns are especially acute where companies face difficulties. As I suggested, that is precisely the situation in which companies need the most able directors, who are willing and able to take the difficult decisions that may be necessary to bring the company out of the position in which it finds itself. That is an important point. We need not only capable people at the top of our leading companies, but high-quality people to put struggling companies back on their feet.

It is clear from the business context why concerns are growing. For example, the action brought by Equitable Life against its former directors has understandably made many business people think twice before accepting a directorship, particularly when they might accept an even more lucrative consultancy role instead. As I suggested, the rise in the number of class actions against directors in the US is also a real concern to directors of companies with US exposure. In fact, it has been estimated that, on average, a non-US company with a US listing has slightly less than a one in 10 chance of being sued as a foreign issuer. An action usually targets the company and the directors, so it is no surprise that directors are becoming concerned.

Such concerns must, however, be kept in perspective. It is, for example, generally difficult under English law for shareholders acting for themselves, not as the company, and for other third parties to bring proceedings against directors, and it is still rare for a solvent company to bring an action against its directors or former directors. Nevertheless, it is clear that concerns about potential liability are having a significant deterrent effect. That is why the Government, listening to those concerns, have put together a balanced and carefully targeted package of reforms to address the key issues that have been identified.

We have tabled two new clauses to implement our proposals, and I shall consider each in turn. New clause 1 amends the provisions in the Companies Act 1985 relating to directors' liability. It does two things: first, inserts in the 1985 Act three new sections, 309A,

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309B and 309C, which replace the existing provisions on directors liability, but not auditors' liability, and secondly, disapplies existing section 310 from directors and other officers.

I shall describe the three sections in detail. New section 309A begins by restating the core prohibition on companies exempting directors from, or indemnifying them against, liability. Many key elements of section 310 of the 1985 Act are retained. In particular, a company is prohibited from exempting a director from, or indemnifying him against, a liability to the company; and a company is permitted to purchase and maintain insurance against any such liability.

There are, however, three important changes from section 310. First, in line with the recommendation of the company law review, the new section does not extend to liabilities of officers other than directors. As the review suggested, it is ultimately a matter for the board to determine the conditions of employment of senior employees. Secondly, respondents to our consultation noted that the law is unclear about the ability of a third party to indemnify a director against a liability to the company. We do not believe that, in most cases, there is a strong case for preventing that—the company's money is not at risk. It is important, however, that other companies in the same group cannot be used to circumvent the prohibition on the company.

If a company itself is not permitted to provide indemnification, it cannot be right for another group company to do so. Subsection (3) of new section 309A therefore provides that an indemnification agreement is void if it is made by the company itself or by an associated company. Subsection (6) defines an associated company as, in effect, a company in the same group.

Thirdly, we wish to address directors' concerns about their exposure to third party liabilities by clarifying the law in respect of the ability of companies to indemnify directors against liabilities to third parties. The Government do not believe that there is an objection in principle to permitting indemnification by the company of directors in respect of third party claims, not least because such claims could—and, arguably, should—be brought against the company.

We also accept that that is a matter of very great importance to many companies and directors. It is more likely that an action will be brought against a director by a third party than by the company, so this is the most urgent and significant issue that needs to be addressed in respect of directors' liability. It is particularly so in the case of companies with an overseas listing, not least because of the inexorable rise in the number of class actions taken in the United States.

Section 309A(4) therefore states that the prohibition against indemnification by a director's company or associated company does not apply to a qualifying third party indemnity provision. A qualifying third party indemnity provision is defined in new section 309B, which sets out three conditions

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that must be satisfied for an indemnity to qualify. Condition A is that a qualifying provision may not provide any indemnity against any liability incurred by the director to the company itself or to an associated company—that relates to my point about our not pursuing the ability of a company to indemnify its own directors.

Condition B is that a qualifying provision may not provide any indemnity against any liability incurred by the director to pay a civil penalty to a regulatory body such as the Financial Services Authority. In other words, one cannot indemnify a director against having to pay the consequences of their action when that action is not approved by a regulatory body .

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Condition C is that a qualifying provision may not provide an indemnity against any liability incurred by the director in defending any proceedings, whether civil or criminal, in which he is convicted or judgment is given against him, except for civil proceedings brought by third parties. That condition is largely the mirror image of the current section 310(3), under which a company is permitted to indemnify a director against any liability incurred by him in defending any proceedings, whether civil or criminal, in which judgment is given in his favour or he is acquitted.

Subject to those conditions, companies would be permitted to indemnify directors in respect of proceedings brought by third parties. Indemnification in those cases could cover both the legal costs and the financial cost of any adverse judgment, except criminal penalties or those imposed by regulatory bodies. That would be of particular benefit to companies with a US exposure, as it would enable them to indemnify directors against liabilities arising from class actions by groups of shareholders.

Proposed new section 309C of the 1985 Act concerns disclosure. It is important in such an area that companies and directors act openly and transparently. We therefore intend to require a statement in the directors' report as to whether a director has been indemnified by the company or by an associated company. That will act as a warning flag to shareholders, who will have the right to inspect qualifying third party indemnity provisions made by the company or an associated company. That right is achieved by applying section 318 of the 1985 Act, under which directors' service contracts must be open to inspection by shareholders. Companies that choose not to indemnify directors will not have to make any such disclosure.

The current section 310 of the 1985 Act covers both director and auditor liability. Although the issues are linked, it is not inevitable that that should be so; indeed, the Companies Act 1929, which first introduced the statutory prohibition, had separate sections relating to director and auditor liability. Under the proposals, the current section would be amended by subsection (2) of the new clause so that it would deal only with auditors' liability, while proposed new sections 309A, 309B and 309C would address directors' liability.

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I come to new clause 2. As I mentioned, the consultation demonstrated two issues, the second being a concern about the cost of legal proceedings, which is understandable. A director against whom a legal action is brought faces both a damaged reputation—the damage may be severe but it is beyond statutory relief—and the prospect of having to fund his own defence, even if the action is malicious or unlikely to succeed. At the moment, a company can indemnify a director who is successful in the proceedings, but arguably, that provision will provide cold comfort to the director at the beginning of a legal action that may last for several years, and in which no help with legal costs is available. The Government therefore intend to implement the recommendation of the independent company law review and Sir Derek Higgs that the Companies Act should allow, but not require, companies to pay directors' defence costs as they are incurred, even if the action is brought by the company itself or is a derivative action.

Section 330 of the 1985 Act currently restricts a company's power to make loans to directors or to enter into certain types of credit transactions with them. New clause 2 therefore inserts a new section—337A—into the 1985 Act to permit companies to pay directors' defence costs, in civil or criminal cases, as they are incurred. The director will, however, be required to repay the loan if he is convicted in criminal proceedings or if judgment is made against him, except where, by means of a qualifying third party indemnity provision under new sections 309A and 309B, which I described, the company chooses to forgive the loan in the case of civil proceedings brought by a third party. Although I accept that in some cases the director might be unable to repay the loan in full, this proposal clearly retains a moral hazard; indeed, the director might be facing insolvency as well as suffering severe damage to his reputation. The two related amendments, Nos. 2 and 3, are entirely consequential on the new clauses and respectively amend schedule 8, which lists repeals and revocations, and the Bill's long title.

In summary, I believe that our package of reforms will provide much needed clarity and will address key concerns that have been raised with us during and outside the consultation process: that we risk being unable to find the best and most talented people to be directors of our companies, or being unable to help them to take difficult decisions; and that we should take into consideration the context within which our companies and their directors must operate. In addressing those concerns in a proportionate and targeted fashion, the new clauses will help to ensure that honest, capable people will still want to become company directors, and will direct our companies in a manner that is important to our overall prosperity and to future jobs in corporate Britain.

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Prepared 14 September 2004