The duty of good faith: An origin story

A duty for board directors to act in good faith and in the best interests of the company is found in most jurisdictions. But fundamental questions around the duty remain unsettled in corporate law.  One such question is to whom directors owe the duty; shareholders at any time, or the company as a separate entity. Those apparently mutually exclusive alternatives speak to underlying paradigm differences in our understanding of what exactly a modern company or corporation is.

Applying an historical lens provides a middle ground answer, revealing that the duty of good faith is owed to the corporation as an entity separate from its shareholders with the interests of shareholders, represented as the capital of the company, held in the entity. 

By 1657 the English East India Company (EEIC) could lay claim to being the world’s first modern company. It had all the old incidences of a corporation including the ability to enter into transactions. It was an artificial legal person. The new charter granted by Oliver Cromwell turned the joint stock contributed by investing shareholders into permanent capital.  Unlike its Dutch equivalent, the VOC, or Vereenigde Oostindische Compagnie (Dutch East India Company), the capital in the EEIC was separated legally and but also for accounting purposes through double-entry book keeping from its shareholders.

Did the duty of good faith and to act in the best interests of the company exist in 1657? Members of governing bodies of all forms of corporation, including business corporations, swore oaths when taking up office. Committees (directors) were required to swear an oath on election ‘that they and every of them shall well and faithfully perform their said office of Committees in all things concerning the same.’ Oaths were not legally enforceable; they added moral obligations to pre-existing legal ones. The supporting nature of the oath did not mean that oaths were pointless, as people believed God would punish those who broke promises. Oaths were particularly useful where fear of men was not a great enough deterrent and where ‘fear of men did not seem effective enough’, and where there was a risk of lack of faithfulness.

John Evelyn, diarist and investor in the East India Company wrote in his diary in 1657 of new oaths, new orders, and a mixed committee in the EEIC. The November 17 meeting of the committees (directors) for the New Stock decided on the wording of the ‘newe oath’ for the EEIC.  The new governing body included investing shareholders. As well as the requirement to faithfully perform their office, the members of the governing body swore to ensure  “that an equall and indifferent hand [would] be carried in the government of this fellowship and in the affaires thereof to all the adventurers [shareholders] that shall adventure or putt in stocke”.

The requirement that members of the governing body not favour their own interests above the interests of all of the stockholders (shareholders) by applying an equal and indifferent hand arose out of conflict in the EEIC in the early part of the 17th century. The controlling elite majority shareholders of the Company were wealthy merchants who made distributions in commodities or purchased commodities from the EEIC at rates favourable to themselves. The merchants had established retail networks where they were able to on sell those commodities. Investing shareholders, who comprised the generality and who had in personam voting rights, agitated through the new forum of the general meeting for distributions to be made to shareholders in cash, and for sales of commodities to be at market rates. The EEIC depended on investment by the generality to mount voyages so eventually gave into their demands.

The ‘newe oath’ also required that “an equall division from tyme to tyme be made to all the adventurers according to the proportion of their several stocke duly paid in.” By 1657 the English East India Company was essentially a capitalist enterprise focused on a return on capital contributed by shareholders, rather than being focused on individual shareholders. The governing body was expected to consider ‘the affaires’ or interests of the shareholders, rather than the shareholders themselves. Thus whilst the fundamental obligation to faithfully perform their office that existed for all members of governing bodies of all form of corporation remained in place, “the newe oath” created obligations to the interests of all shareholders held as permanent capital in the EEIC.

In Charitable Corporation v Sutton in 1742 Lord Hardwicke recognised the duality in the role of directors. stating: “I take the employment of a director to be of a mixed nature. It partakes of the nature of a public office, as it arises from the charter of the crown. But it cannot be said to be an employment affecting the public government; and for this reason none of the directors of the great companies, the Bank, South-sea &c., are required to qualify themselves by taking the sacrament. Therefore committee-men are most properly agents to those who employ them in this trust, and who empower them to direct and superintend the affairs of the corporation … By accepting of a trust of this sort a person is obliged to execute it with fidelity and reasonable diligence.”

Lord Hardwicke recognises the long-existent obligation of office but distinguishes the oath that directors of business corporations are required to swear because they do not need to take the sacrament. Lord Hardwicke might appear to classify committee-men [directors] as agents of shareholders. It should be noted though that the concept of an ‘agent’ had a different meaning in 1742- it related to the agent being the doer of a thing with agency, as a significant and discrete subject did not emerge fully until the turn of the Nineteenth Century.

The significance of Sutton is that the mixed nature of role of director, the public aspect relating to office and the private aspect relating to shareholders was turned on its head so that the secondary obligation owed by directors of business corporations to the interests of shareholders – (those who ‘employ them in this trust, and who empower them to direct and superintend the affairs of the corporation’)  (arguably) became paramount from that point on.

Although Charitable Corporation v Sutton is frequently credited as the origin case for directors’ duties, the good faith obligation was not initiated in Sutton but rather in the earlier oaths sworn by all members of governing bodies of all forms of corporation. The  obligation to the interests of shareholders of business corporations emerged in 1657 in the oath sworn by directors of the  EEIC folllowing agitation by investor shareholders. Although clearly a watershed case, The Charitable Corporation v Sutton was a more incremental development than a leap.

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By Susan Watson, Professor of Law at the University of Auckland Faculty of Law and the University of Auckland Business School and ECGI.

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