Developed piecemeal through the years, the rules governing U.K. companies remained the statutory equivalent of a pocketful of cocktail napkin scribbles. A law about shareholder communications here, another about transactions there. The large body of common law was an enigmatic nightmare for in-house counsel.

Parliament decided to alleviate the nightmare in 2006 by lumping all these laws into a single piece of legislation. Most companies supported the initiative, which received royal assent in 2006. However, what they got wasn't what they bargained for.

The Companies Act 2006 contained 700 pages and nearly 1,500 clauses–making it a cumbersome reference manual at best. It also contained a host of new laws. One in particular has many companies up in arms. It is a sweeping rule that places new duties on directors and, according to some experts, leaves companies and their directors vulnerable to shareholder suits.

“One concern is that these new duties give a greater window of opportunity for shareholders to allege that directors have breached their duties,” says Carol Shutkever, partner at Herbert Smith in London.

Promoting Success

The new director duties come at a time when U.K. investors are demanding more corporate accountability. For example, in 2002 the ghost of Enron managed to creep across the Atlantic, leading to the indictment of three British bankers on fraud charges.

“In part, this act attempts to establish a set of rules for corporations so that the U.K. is seen internationally as a safe place for corporate investment,” says James Cox, partner at Gibson, Dunn & Crutcher in London.

To make it a safer investment environment, legislators decided to create a new set of fiduciary duties for directors. Under common law, a director had to act in the company's best interest. Under the new law, a director has a duty to act “in a way he considers most likely to promote the success of the company.”

“To a layman, there's not a big difference between the old and new laws,” says James Burdett, partner at Baker & McKenzie in London. “But the general feeling in the U.K. is that this new duty is different, or at least can be different, than merely acting in the best interest of the company.”

The scenario of a hostile takeover highlights the differences between the old and new laws. If the board of the target company must promote the company's success, directors may have to fight off the hostile takeover at all costs, even though it might be in the shareholders' best interests. It is the word “success” that perplexes experts, who say it is up to the courts to define the term.

The Act also establishes a list of social factors directors must consider when making business decisions. Those include such things as the decision's impact on the employees, surrounding community and environment.

“When considering how a decision will affect the success of a company, directors also have to consider these factors,” Shutkever says. “So the idea is that if the company is doing something that is bad for the environment, it is likely going to be bad for the success of the company as well.”

The trouble comes when these factors conflict. For example, if a company has a factory that is environmentally unfriendly and the board wishes to close it, doing so would be bad for the factory's workers.

Minority Actions

Another concern with these social considerations is they give shareholders more ammunition to sue for breach of duty.

“If the board fails to take into account one of these factors, the aggrieved shareholders who have suffered a loss may be able to require the company to bring an action against a director,” Burdett says.

What's worse is the Act also makes it easier for minority shareholders to file claims. Under the old law, only a majority of shareholders could file a suit against a director. Now, minority shareholders can file suit too.

“One of the concerns is that people with an ax to grind could potentially say, 'We don't believe the board took into account all the factors, so we are going to launch this action,'” Shutkever says. “Only time will tell the success of such actions depending on the courts' reaction to these sorts of suits.”

However, the law does establish a three-part test minority shareholders will have to pass to win such claims. First, the shareholder must seek the court's permission to bring the claim. This is a way to weed out vexatious litigants early on.

Second, the court will hold a preliminary hearing to see if the claim should move forward. This hearing will be based on certain tests such as whether a director's decision really was promoting the company's success or was actually made for selfish gain.

Finally, the last stage is the actual trial, which will determine whether the board's actions truly wronged the shareholder and whether the court should award damages.

Paper Trail

In light of these developments, experts are advising directors to take detailed notes during board meetings.

“As with any potential litigation process, it is much easier to defend a decision that was made if there is a contemporaneous note explaining the decision,” Cox says. “For this reason, board minutes will become more detailed than they were in the past.”

But developing and maintaining this paper trail isn't the only crucial element of protecting the board in the event of a shareholder lawsuit. Because the chances of litigation will likely increase after the new Act passes, board members will need to make sure they are properly insured in the event of a claim.

“The [D&O] policy should be broad enough to cover directors in a range of circumstances,” Cox says. “Yet, insurance is becoming increasingly expensive post-SOX.”

Because the new director laws won't go into effect until the end of the year, in-house counsel and directors will have some time to check their D&O polices and get their houses in order.

“Directors are ultimately responsible for understanding their duties, but someone will have to explain what those duties are,” Cox says. “That unfortunately will be the new burden of in-house counsel.”