Corporate Governance and Non-Executive Directors: A Good Start But Not Enough - Essay Example

?Corporate Governance and Non-Executive Directors: A Good Start But Not Enough This paper analyses the extent to which corporate governance issues had been resolved as a result of the greater role being played by non-executive directors. In fine, this paper argues that whilst there have been some measures put in place as a result of the assumption of non-executive directors, there still are a plethora of issues and problems that need to be addressed and resolved, including the degree to which directors can be held liable for wrongdoing and the existence of mechanisms to ensure redress for corporate malfeasance and misfeasance. It is only through a wholistic approach in corporate governance that a definitive solution may be reached. Parkinson was correct when he posited that the internal affairs of a corporation should not be insulated from regulatory intervention.(1993) The recession that has hit much of Europe and America and the widely-reported corporate scandals have highlighted the need to make corporate governance at the top of a company’s order of priorities and the overriding principle guiding its directors. The escalating protests in Wall Street in the United States demonstrate growing public outrage against corporate greed and white-collared crimes. In the United Kingdom, corporate scandals in the United States such as Enron, had at first been dismissed by the UK, believing at first that the mechanisms the latter had in place were enough to exact accountability from errant directors. However, this complacency had yielded when the revelations of corporate greed became more and more shocking. Public trust in capitalism had wavered to a degree heretofore unheard of and soon it became necessary for the UK to revisit its existing measures and determine if these measures were indeed enough. The UK government then embarked on a series of consultations, which resulted in reports that this paper will outline in greater detail later. The reports contained findings on problem areas in corporate governance and some prescriptions. By corporate governance, this paper adopts the definition in the Cadbury Report which defines the phrase simply as “the system by which companies are directed and controlled.” (1992) This definition was extended by the Organisation for Economic Co-operation and Development (OECD) which states that corporate governance “involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders [that provides] a structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined.” This paper will take on three parts. Firstly, it will discuss the contextual backdrop of the problem, specifically the gravity of the situation that warrants the need to create greater accountability measures against errant directors. Secondly, it will look at the policy prescriptions laid in place by the Cadbury report, the Greenbury report, the Hampel report and finally the Higgs report. Thirdly, it make reflections on whether or not the addition of Non-executive Directors (NED) can significantly help in promoting corporate governance. The discipline of directors In a company, virtually all policy-making is left in the hands of the Board of Directors or on the majority shareholders. While allowing directors to control business strategies has merit – for instance, decision-making is streamlined and businesses largely depend on the need to be able to respond to issues not only with soundness but also with dispatch -- some problems inevitably arise. Hence, the need to discipline errant directors has been discussed at length. In theory, a director, holding as he does a position of trust, is a fiduciary of the corporation (Dignam and Lowry, 2010). As such, in cases of conflict of his interest with those of the corporation, he cannot sacrifice the latter without incurring liability for his disloyal act. The fiduciary duty has many ramifications, and the possible conflict of interest situations are almost limitless, each possibility posing different problems. There will be cases where a breach of trust is clear, as where a director converts for his own use funds or property belonging to the corporation, or accepts material benefits for exercising his powers in favour of someone seeking to do business with the corporation. (See Bourne, 1994, 1995) In many other cases, however, the line of demarcation between the fiduciary relationship and a director’s personal right is not easy to define. What is clear, however, is that shareholder conflicts are prevalent in virtually all jurisdictions and the law has to formulate appropriate channels of redress in order to resolve these conflicts. As Miller said, it is one of the most common reasons in the world for people to go to court. (1999) There is no surfeit of examples to demonstrate how minority shareholders and their interests can be prejudiced by the director or those with controlling interests in the corporation. One of the most typical situations of self-dealing is the fixing of directors’ and officers’ compensation (Davies, 2003). This may take various forms – per diems, salaries and profit-sharing arrangements like bonuses, stock option plans, and the like. (Conyon, Peck, Reed, Sadler, 2000: 480). Abuses may arise where the executives concerned are at the same time directors of the corporation, or have a dominating influence over them. Said Conyon, et. Al. “Much of the evidence from empirical work on the determinants of compensation received by top executives has concluded that there is only a very weak statistical link between direct compensation (ie., excluding shareholdings and options) and the market performance of their companies.” (ibid.) What this tends to demonstrate is that errant directors will continue to give themselves lavish salaries and allowances, regardless of profits of the corporations; whilst ordinary shareholders reap benefits only when the corporation profits. To quote Demott (1999: 243): A central question that underlies many analyses of corporate governance is whether the law and legal institutions have a constituent role in shaping governance practices, or whether the law, as well as governance practices, are best viewed as the inevitable results of market forces, centered upon capital markets. A separate, but related question, is the degree to which mechanisms of governance – such as shareholder voting, take-over bids, independent directors, mandatory disclosure, and shareholder litigation – can function adequately as substitutes for one another. Evolution of corporate governance mechanisms The move to develop the notion of corporate governance and make it apply to corporate enterprises in the United Kingdom began in the late 1980s to the early 1990s, as a result of corporate scandals like Polly Peck and Maxwell. The idea of corporate governance is rooted in the idea of agency. Those who infuse capital into a business enterprise hire managers to run the business for them and see to its day to day affairs. The board of directors and the institutional investors also play a role in the monitoring and control of firms. However, the relationships of these players – to each other and to the general public -- must not be left alone and unregulated. It is imperative that there be well-established rules for companies to follow as they navigate the course of the growth. The first report was the Cadbury report, which came at the heels of the Polly Peck scandal and made several policy prescriptions involving rules for the appointment of directors and composition of the board, the salary of executive directors, internal controls and external audits. After that, in 1995, there was a huge public outcry because of the hefty salaries being given to the directors. The Greenbury report was then commissioned. It took off from the Cadbury report but was the first to introduce the notion of non-executive directors who have no pecuniary interest in the company, would report directly to the stockholders and can make recommendations for corporate governance mechanisms using the vantage point of a disinterested person. The NEDs would, in particular, be in charge of pegging the salaries of the directors, to ensure that the interests of the company would continue to be served and corporate greed be reined in. Following that, the Hempel report which reviewed the Cadbury report and the Greenbury report and came up with the Combined Code. The Combined Code had no binding force but was instead composed of a set of principles, which made recommendations to companies to ensure transparency and accountability mechanisms. In 2002, David Higgs was commissioned to come up with a report on non-executive directors and whether or not a more expansive role was warranted with respect to them. The Higgs report came out with clear recommendations for non-executive directors. They were to meet at least once a year without the chairman or executive directors, such meeting to be recorded and expressly stated in the annal report. The NEDs should conduct due diligence on the board and the company. They shall also exercise power over the recruitment and appointment process, and the nomination committee should be composed of a majority of independent, non-executive directors. In order to ensure independence, the Higgs report set forth the following criteria. An individual is disqualified from being a NED if he or she: is a former employee of the company or group, until five years after employment (or any other material connection) have elapsed; has, or has had within the past three years, a material business relationship with the company, either directly or as a partner, shareholder, director or senior employee of an organisation that has such a relationship; has received or receives extraremuneration from the company (apart from a director’s fee), participates in the firm’s share option plan or performance-related pay scheme, or is a member of its pension scheme; has close family links with any of the company’s advisers, directors or senior employees; holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; represents a shareholder with a significant stake; has served on the board for more than 10 years.(Higgs Report, 2002) From this series of consultations and recommendations, the Company Law Act 2006 was enacted. The major purposes underlying the UK’s Company Act of 2006 is to protect shareholder rights, to ensure directors’ responsibility, to promote corporate governance – all of which will, in the end, facilitate a better policy environment for commerce and trade. The Companies Act – previously known as the Company Law Reform Bill -- received its second reading in the House of Lords on January 11, 2006, and received Royal Assent on November 8, 2006. As stated by Lord Sainsbury, Parliamentary Under-Secretary of State at DTI, the purpose of the Act is to “to constantly update company law in response to changes in the way companies do business”1. According to Lord Sainsbury, the Act has four key objectives: Enhancing shareholder engagement and a long-term investment culture Ensuring better regulation and a “think small first” approach Making it easier to set up and run a company Providing flexibility for the future. The Company Act had indeed introduced important and innovative reforms to facilitate corporate governance and protect the rights of shareholders. NED: Only half the solution As important as the recommendations towards the greater role of NEDs are, it is only half the solution. It does not take into account the remedies of shareholders in situations wherein, despite the heightened role played by non-executive directors, errant members of the Board still wreak havoc on shareholder rights. It cannot be gainsaid that minority shareholders occupy a vulnerable and precarious position in the hierarchy of the corporate structure. The dilemma that of how one is to go about preserving their rights and granting them protections is akin to the dilemma that faces a democratic polity: while the will of the majority is a foremost consideration and indeed is the most equitable way to resolve disputes and frame policies, there is an equally compelling and equally valid need to have regard for the interests of those in the minority – marginalized sectors who face constant threat of being disenfranchised in a system founded on justice and fairness. The part of the Act that is most relevant to shareholder engagement is Part 11, which provides shareholders with, as stated in paragraph 480 of the Explanatory Notes, “a new procedure for bringing such an action which set down criteria for the court distilled from the Foss v Harbottle jurisprudence". (Companies Act 2006, Introductory Notes) The Foss v. Harbottle rule which was explained by Prentice in this wise: The rule in Foss v. Harbottle can be stated with disarming simplicity. Basically, there are two branches to the rule. First, “the proper plaintiff principle”, which provides that in any action asserting rights inhering in a company, the proper plaintiff is the company itself, and secondly, the “internal management principle”, whereby the courts will not interfere with the internal management of companies acting within their powers.” (1972: 318) It can be argued that there are justifications for this “notoriously-difficult” (Slutsky, 1976: 331) rule, and they may be considered separate principles in themselves. This is supposedly also to lessen vexatious litigation instigated by disgruntled minority stockholders to oppose policies laid down by management in the exercise of its discretion, and to prevent companies from being torn apart by litigation (Slutsky, 1976: 335). In a contract, parties have mutual obligations, and by buying shares in a given company, stockholders undertake to abide by policies made by the Board of Directors in the exercise of their discretion. This suggests that disputes should always be dealt with first using the internal machinery of the company. This principle is consistent with the notion that those who voluntarily take the position of directors and invite confidence in that relation, undertake that they possess at least ordinary knowledge and skill and that they will use them in the discharge of their functions as such. The main problem is that though there has been a considerable liberalization of the concept, and it has been comparably easier for minority shareholders to seek redress for the oppressive conduct of majority shareholders, many legal thinkers maintain that the legal climate in the United Kingdom is still weak in regulating such forms of corporate oppression. While in the US the market for corporate control, manifest in takeovers, provides a powerful incentive towards good corporate governance, these mechanisms have remained weak in the UK. (Garrod, 1996) Parliament was able to somewhat address the rigidity and inflexibility of the Foss v. Harbottle doctrine mainly through the concept of “fraud on the minority”. “Fraud on the minority” involves two elements. The first is a cause of action in the company that can be characterised as an equitable fraud. Fraud includes all cases where the wrongdoers are endeavouring, directly or indirectly to appropriate themselves money, property or advantages which belong to the company or in which the other shareholders are entitled to participate, according to Burland v. Earle [1902] AC 83, 93. The second element is control of the company by the wrongdoers. Under the U.K. company law, the court has broad discretion to make remedial orders if there has been unfairly prejudicial conduct (including orders to regulate corporate conduct or purchase a shareholder's stock). (Miller 1993) However, there still were some gaps and holes that needed to be filled. For example, the linkage with winding up claims posed as a major roadblock to the right of minority shareholders to seek redress. Another problem was that minority shareholders needed to prove that the conduct was oppressive. What this succeeded in doing was set a very high threshold, making it nearly impossible for minority shareholders to initiate a suit against the majority. S75 CA 1980 amended the law by providing answers to the questions raised by s210. Most significantly, it removed the link with winding up petitions. S459 amended it even further, and its most substantial contribution is that it lowered the threshold. A plaintiff no longer has to prove “oppression”. Rather, he only needs to prove “unfair prejudice”2. It must be noted, however, that an s459 remedy is not the same as a derivative suit. Said Reisberg, “the unclear interaction between the two remedies projects an uneasy shadow, which in turn affects the viability of derivative actions.” (2005: 227) The rather confusing panoply of laws is perhaps best reflected in Lord Hansard’s statement, “Many have argued that Clause 239, rather than mirroring the common law as the Government claim, in fact goes further. The common law is uncertain. These provisions have not been much used and the outcomes have sometimes been conflicting, so it is hard to specify exactly what the current position is.” It makes the rules pertaining to minority shareholder rights quite complex and may discourage minority shareholders from availing this right. Conclusion In conclusion, expanding the role of non executive directors is a good step forward, but it is not enough. It is also imperative to untangle the rules on shareholder remedies, post-violation. The desire to ensure the stability of business and protect commerce in the United Kingdom should be balanced by the equally-compelling need to protect the rights of minority shareholders. Though legal and economic conceptions have both rested on and have been shaped by the normative implications of ownership (Grantham, 1994), it should also be animated by equity and corporate responsibility. For indeed, if what is sought in the long-term is a robust commercial system supported by a legal regime that protects rights, accommodates as many players as possible and will not countenance fraud or breach of duty of those wielding power, then wealth generation will simply not be enough – ensuring the long-term sustainability of the company through an adequate and accountable corporate governance framework is key. References Bourne, N. (1994) Essential Company Law, London: Cavendish. Bourne, N. (1995) Company Law, London, Cavendish: (1995). Cadbury Report: The Financial Aspects of Corporate Governance. (1992). Available at http://www.ecgi.org/codes/code.php?code_id=132 Conyon, Martin; Peck, Simon; Read, Laura and Sadler, Graham. (2000) “The Structure of Executive Compensation Contracts: UK Evidence.” Long Range Planning 33. 478-503. Davies, P. (2003). Gower and Davies’ Principles of Modern Company Law, 7th ed. London: Sweet and Maxwell. DeMott, Deborah A. (1999) “The Figure in the Landscape: A Comparative Sketch of Directors' Self- Interested Transactions” Law and Contemporary Problems, Vol. 62, No. 3, Challenges to Corporate Governance, pp. 243-271. Dignam, A. and Lowry, J. (2008). Company Law 5th Ed. Oxford: Oxford University Press. Garrod, N., (1996), Environmental Contingencies and Sustainable Modes of Corporate Governance, Paper presented, Faculty of Economics, University of Ljubljana. Grantham, Ross. “The Doctrinal Basis of the Rights of Company Shareholders.” The Cambridge Law Journal. Vol. 57 (1998). 554-588. Hannigan, B. (1995) Company Law. London: Butterworths. Higgs Report: Review of the Role and Effectiveness of Non-Executive Directors. (2003). Available at http://www.ecgi.org/codes/code.php?code_id=121 Miller, Sandra K. (1999) “How Should U.K. and U.S. Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct Be Reformed?” American Business Law Journal, Vol. 36. No. 3, pp. 318-321. Parkinson, J. (1993). Corporate Power and Responsibility: Issues in the Theory of Company Law. Oxford: Clarendon Press. Prentice, D.D. (1972) “Another Exception to the Rule in Foss v. Harbottle.” Modern Law Review, Vol. 35. Reisberg, Arad. (2005) “Shareholders' Remedies: The Choice of Objectives and the Social Meaning of Derivative Actions.” European Business Organization Law Review. 227-228. Slutsky, B.V. “Shareholders' Personal Actions. New Horizons” Modern Law Review, Vol. 39, No. 3 (May, 1976), pp. 331-335. Starovic, D. and Hayward, C. (2003) “The Role of the Non Executive Director: Making Corporate Governance Work.” Cimaglobal.com. http://www.cimaglobal.com/Documents/ImportedDocuments/NEDSmakingcorpgovwork_techguide_2003.pdf Read More