Many start-ups suffer in the long term from overlooking an essential legal consideration in their early stages

 

You might have heard the principle in English company law of ‘separate legal entity’. This principle allows your company to become a legal person under the eyes of the law, meaning it can sue and be sued, can sign contracts, employ people, open bank accounts, and whatever else a self-employed individual or sole trader might do in order to run its business.

Of course, technically speaking, no company is a physical person. This means a company needs someone — a flesh and blood director — to carry out tasks on its behalf.

The main issue with start-ups, however, is that the significance of this role doesn’t match the ease with which individuals can become a director soon after their great business idea pops into their mind. The first thing any start-up entrepreneur will do is jump on the Companies House website, which will then take them through the easiest ever process to set up a company. All in all, it will take 15 minutes at the most for you to have an incorporated LTD.

Under section 154 of the Companies Act 2006, it is required that all companies must have at least one director — a process that requires one to input, effectively, the same amount of information you would provide on a Facebook registration form. Most start-ups will have registered as directors its co-founders, and start calling them names such as ‘CEO’, ‘CTO’, and ‘CFO’.

Of course, as far as the law is concerned, you can call yourself ‘CBO’ (Chief Banana Officer) as long as you are registered with Companies House as a director. In the eyes of the law, any person occupying the position of a director — whatever way they choose to refer to themselves — is a director (see section 250 of the Companies Act 2006). The main issue that this raises is that being a director implies binding legal responsibilities. Since the moment you start to take on investments — and therefore bring on board shareholders — you effectively bring people in who can ensure a director upholds their responsibilities.

The problem, particularly among start-ups, is that many do not know that these duties are not simply a reminder to be nice to one’s shareholders. Rather, if you are in breach of any of these duties your shareholders may, under subsections 260-264 of the Companies Act 2006, bring an action at law against you as the director of that company. Moreover, if the outcome is in the claimant’s favour, the director in question can be dismissed and even disqualified from acting as one in future; effectively kicking the director out from the company in both cases.

There are presently seven key duties codified under the Companies Act 2006 sections 171 to 177, which reflect the common law and equitable principles: the duty to act within powers; the duty to promote the success of the company; the duty to exercise independent judgement; the duty to exercise reasonable care, skill and diligence; the duty to avoid conflicts of interest; the duty not to accept benefits from third parties, and; the duty to declare interest in proposed transaction or arrangement.

While most of these duties may not be applicable, or of great relevance at early stages, I believe that greater weight should be given to section 174 of the Companies Act 2006: the duty to exercise reasonable care, skill, and diligence.

The court applies a solely objective standard to section 174. This requires you as a director to possess the general knowledge, skill, and experience that may reasonably be expected of a person carrying out the functions performed by a director in relation to the company. Furthermore, a subjective test is included in section 174. This is only used to raise the set objective standard to a greater level if the director, by means of certification or experience (e.g., an MBA), is believed to have known better.

Inexperience, therefore, will not be an excuse to lower the objective standard.

However, a few factors must be noted before we bring this discussion to an end. Firstly, an action under subsections 260-264, as previously explained, will not entitle the claimant to damages, meaning there is no pecuniary gain. Therefore, a derivative action must be funded with the mindset that the money spent to bring the action in court will be forever lost. Furthermore, causation must be proved. I will not be able to explain in-depth here the principles underlying this legal notion of causation, all that you need to know at this stage is that causation is a very hard and lengthy matter to prove.

These factors will, therefore, make it less likely for any reasonable person to bring forward a derivative action.

Secondly, all the duties work somewhat together; meaning, considering a single duty while ignoring the others is neither good practice nor advisable. Lastly, 200 years of common law and equitable principle have just been codified in the (single) Companies Act of 2006. Its codification of the director’s duties has been widely criticised as being too vague. This means that common law has now greater power to steer towards different directions, in order to make the law clearer. Though peculiar cases will attract peculiar judgements, it is nevertheless important to keep in mind that common law is still of great importance to interpreting correctly the duties of a director.

This article’s main purpose has been to make young entrepreneurs aware of, and to encourage them to become informed about, the legal implication of a director’s duties. After all, if these duties are not diligently followed, such implications may result in the loss of the work of a lifetime (see, for example, Steve Job’s loss of his company in 1985).