UK Approach to Corporate Governance - Assignment Example

Introduction This paper focuses on the issue of how far the UK approach to corporate governance effectively balances the interests of the owners and management of listed public companies. Undoubtedly, the most dominant system of corporate governance in large corporations is the separation of ownership and control.1 The separation of ownership and control describes the internal governance structure of corporations by which a large degree of distance or separation has emerged over time between the shareholders of the corporation (ownership) and the directors and senior managers of the corporation (control). The directors and senior managers exercise day-to-day control in relation to the affairs of the corporation, and are responsible for the main operational and strategic decisions affecting the corporation. Individual shareholders, on the other hand, have very little involvement in the day-to-day affairs of the corporation, particularly in large corporations where there are an enormous number of shareholders, with each holding only a fraction of shares, and therefore at best capable of very little influence. Commonly, individuals invest in a corporation and have no continuing involvement with it, except for receiving dividend payments and voting on resolutions and attending general meetings. Accordingly, it is arguable that the separation of ownership and control inevitably produces a situation of shareholder passivity. This paper analyses the effectiveness of the UK approach to protecting the shareholders interest within the structure of this “separation theory”. For this purpose we define corporate governance from a legal perspective as a system whereby directors are entrusted with responsibilities and duties in relation to the direction of a company’s affairs.2 In this first part of this paper we discuss how UK law protects the interests of the shareholders and in the subsequent part we shall address the issue of the effectives of the UK approach. Part I: The UK Approach to protecting Shareholder Interests A. Legal Relationship between Owners and Management: Directors’ Duties Company law imposes two main duties on directors: the first is the common law duty of care and skill which arises from the fact that directors are professional entrepreneurs and managers and are thus expected to perform their duties with utmost care and skill.3 The other duty is a fiduciary one which arises from the nature of the director’s responsibility as a trustee who preserves company assets for shareholders.4 This duty encompasses four elements: the duty to act bona fide in the interests of the company and not for any collateral purpose; the duty to exercise company powers for a proper purpose; the duty not to appropriate assets belonging to the company; and the duty to not put themselves in positions where their personal interests conflict with those of the company. It is also clearly established that this duty is owed to the company and not to shareholders.5 The law, however, provides for shareholder litigation both at common law and at statute. Shareholders can therefore bring derivative and personal actions against directors for breach of their duties. The law also provides for shareholders to act as monitors. Apart from bringing actions against directors, shareholders have the right to hold management accountable. They consider annual reports and accounts as well as vote on their remuneration packages in annual general meetings (“AGMs”). Shareholders can also appoint and remove directors at AGMs or extra-ordinary general meetings, a power they use to ensure that directors act in line with shareholder interests. Shareholders also secure accountability via disclosure requirements and the role of auditors and the audit committee. Auditors are appointed by shareholders at AGMs and owe a duty to shareholders to ensure that company accounts reflect a true and accurate representation of the company’s financial position.6 B. Fiduciary Duty: No-conflict Rule & No-profit Rule The fiduciary duty of the directors implies that the directors should not take decisions which promote their interest and overshadows the interests of the shareholders of the company. The principle against conflict of interest can be traced to Aberdeen Railways Co v Blaikie Bros,7 where Lord Cranworth states that no fiduciary director shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which may possibly conflict, with the interests of those whom he is bound to protect. The no-conflict rule established in this case allowed a company to avoid any contract which the directors entered into on its behalf in which one or more of the directors had an interest, unless that interest had been disclosed to the company and approved by the general meeting. The disclosure of directors’ interests in corporate transactions is important for the application of the no-conflict principle. As can be seen from the Court of Appeal case in Harrison (Property) Ltd v Harrison, a director who failed to make sufficient disclosure of his interest on the purchase of a property from the company some 11 years before proceedings were commenced was held liable to account for the profits made from the transaction.8 Finally, directors owe a duty not to make secret profit, which has now come to be known as the ‘no profit rule’.9 The no-profit rule is derived from the Keech v Stanford case but the leading authority for the application of the no-profit rule was Regal (Hastings) Ltd v Gulliver.10 In this case, the House of Lords held that the directors had made their profits by reason of the fact that they were directors of Regal and in the course of the execution of that office. As noted above, the directors’ duty is two fold: [1] fiduciary and [2] duty of care. In the United Kingdom the common law standards of reasonable care and skill were summarised by Romer J. in City Equitable Fire Assurance Co, Re, as comprising three main propositions:11 1). a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected of a person of his knowledge and experience; 2). a director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings, and at meetings of any committee of the board upon which he happens to be placed. He is not, however, bound to attend all such meetings, though he ought to attend whenever, in the circumstances, he is reasonably able to do so; 3). in respect of all duties that, having regard to the exigencies of business, and the articles of association, may properly be left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly. Under the principles established by the case of City Equitable, it appears that few directors, if at all, would ever been found liable in negligence for the corporate losses which resulted from what appeared to be clear mismanagement of the company’s business. However although City Equitable still remains good law, it is notable that the scope and extent of those obligations is somewhat vague, since there are no generally recognised standards of the degree of skill and care, and the elements of the test are out of date and not robust enough for the protection of the interests of a company in modern times.12 Nevertheless, these propositions have been substantially modified by the later case laws and statutes. In Dorchester and Finance Co Ltd v Stebbing,13 Foster J. applied the proposition laid down in City Equitable but held that non-executive directors who were qualified accountants or who had considerable accountancy and business experience had been negligent in signing blank cheques which allowed the managing director to misappropriate the company’s money. This implied that the professional directors would use reasonable skill in performance of the duties of the office based on what might reasonably be expected from a person in their position. And since the role of non-executive directors have become more pronounced than it was when City Equitable was decided we shall consider it more detail, infra. C. Role of Non-Executive Director in Context of Corporate Governance The nature of the role of a non-executive director, as Margarita Sweeney-Baird says, can be anything that the company wishes it to be because it is governed primarily by the employment contract between the company and the non-executive director and the role is not defined by legislation, though technically and legally speaking there is no difference between a executive director and a non-executive director.14 However, today greater thrust is being placed on the position of non-executive director as far as principles of corporate governance are concerned. Non-executive directors are now widely seen as an important part of corporate governance structure, and specifically as “oversight” machinery. The importance of the role of non-executive directors have also be highlighted by the coming into force of the Combined Code on Corporate Governance published by the Financial Reporting Council in 2003. The Combined Code takes into account the role and the responsibilities of the non-executive director and acknowledges the need for independent non-executives15 and the importance of the non-executive directors on the audit, nomination and remuneration committees. The Combined Code also stresses on the need for a formal, rigorous and transparent procedure for the appointment of new directors to the board and identifies certain support systems that can be put in place to enable them to perform their role most effectively, such as: a. training for non-executive directors; b. suggesting that courts when determining liability of directors they should take note of the steps taken by the non-executive directors to educate themselves and the instructions that they have received from the executive board.16 Section 1A.1 of the supporting principles to Combined Code highlights the importance of the role of a non-executive director, which reads as follows:17 As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinize the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning. The need to foster a non-normative regime to foster the principles and ethics of corporate governance through the aid of independent, supervisory non-executive directors was also highlighted by the recommendation issued by the European Commission on February 15, 2005.18 The recommendations can be briefly surmised in the following points: a. separate committees comprising mainly independent non-executive directors be created to take responsibility for nomination, remuneration and audit b. non-executive directors are required to be appointed for a specific term and to have the ‘right background’ and have sufficient time to fulfil the role; c. a tailored induction program for non-executive directors which includes their responsibilities and the company’s organisation and structure. It is worth noting that, as we have seen above in this paper, these recommendations of the European Commission have already been substantially covered by the Combined Code. Part II: UK Approach to Corporate Governance: How effective is it to protect shareholder Interests? As we have seen in the opening paragraphs of Part I of this paper, UK approach to corporate governance has been traditionally built on the foundation of management’s obligation to protect and maximize the interests of the shareholders. The statutory duties that the non-executive directors are subject to apply equally to all directors and are to be found mainly in the Companies Acts and the Insolvency Act of 1986. A. Statutory Obligations on the Directors of the Company The Companies Acts provisions include administrative and accounting duties such as the duty to keep books up to date and the duty to file annual returns. Insolvency Act 198619 impose criminal and civil liability on the non-executive director where the company continues to trade when the non-executive director knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation or if the non-executive director knowingly continues to carry on business with the intention of defrauding creditors in the knowledge that there was no reasonable prospect of the creditors being paid by the company.20 Liability can also be imposed on the non-executive director through a raft of statutory law including health and safety regulations, environmental legislation, the Company Directors Disqualification Act, 1986, competition law and financial services law. The Disqualification Act of 1986 applies to non-executive directors and has the practical effect of raising standards of skill and care. Further, a director may still be found unfit even though no breach of a legal duty has been established.21 The range of potential liabilities for the non-executive director is considerable. The Companies Act, 1985 has incorporated various other provisions also to make the directors accountable to the shareholders are legally bind them to act in the best interests of the members of the company.22 However it is also evident that many principles regulating directors’ behaviour are established by case law rather than in a provision of the Companies Act 1985. Conclusion As we have seen above, the law has continuously evolved to effectively put in place a corporate governance structure to balance the interests of the shareholders and the management. However, on the flip side this has further exacerbated the legal regime owing to the complexity and overlap of the many and varied rules governing directors’ duties have made it difficult for directors to understand what to do before they act. Furthermore, the heightened role and responsibility that has been vested and bestowed on non-executive directors tend to be a potential source of conflict between the non-executive directors and the other management officials (including executive directors) of the company23 thereby ending in disastrous business consequences. A partial way forward has been formulated with Law Commission and the Scottish Law Commission’s joint report entitled “Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties”, which clarified that there should be a statutory provision codifying the principal duties of company directors. In 2002, the CLRSG24 took a step further and proposed a statutory statement of duties and recommended in its Draft Bill that the general duties imposed on directors should be put on a statutory footing, to provide greater clarity on what is expected of directors and make the law more accessible, to make development of the law in this area more predictable and to correct the defects in the present duties relating to conflicts of interest. This Draft Bill was superseded by Part B of the Company Law Reform Bill published in April 2005 and is now included in Part 10 and Sections 154 to 238 of the Company Law Reform Bill.25 The provisions in the proposed Section 158 require directors to exercise the care, skill and diligence of a reasonably diligent person with knowledge, skill and experience which may reasonably be expected of a director in his position, and any additional knowledge, skill and experience which the particular director has. It may be reasonably anticipated that this statement of the expected duties of the non-executive director would clearly endorse the application of both the objective and the subjective duty of care applicable to the non-executive director cumulatively and would endorse cases that are bringing the common law duty of care of a director closer to the standard imposed by Section 214 of the Insolvency Act, 1986. In view of this it is arguable that the statement of directors’ duties will provide a much needed clarity to the directors’ duties in common law that will provide more specific guidance to the non-executive director of what is expected of him as a part of the management of the corporation. Bibliography A. Statutes, Guidelines & Recommendations 1). Companies Act 1985 2). Insolvency Act, 1986 3). Company Directors Disqualification Act, 1986 4). Combined Code on Corporate Governance, 2003 5). Company Law Review, Modern Company Law for a Competitive Economy, Final Report November 2002 B. Judicial Decisions 6). Keech v Sandford (1726) Sel. Cas. Ch. 61 7). Regal (Hastings) Ltd v Gulliver [1942] 1 All E.R. 378 8). Percival v Wright, [1902] 2 Ch. 421 9). Aberdeen Railways Co v Blaikie Bros (1845) 1 Macq. 461 (HL) 10). City Equitable Fire Insurance Co Ltd, Re [1925] Ch. 407 11). Dorchester Finance v Stebbing [1989] B.C.L.C. 498 C. Treatises & Works of Publicists 12). James McConvill, The Separation Of Ownership And Control Under A Happiness-Based Theory Of The Corporation 26(2) Comp. Law. 35-53 (2005) 13). S. Sheikh and S. K. Chatterjee, Perspective on Corporate Governance, in Corporate Governance & Corporate Control (Saleem Sheikh and William Rees eds, Cavendish, London, 1995) 14). Ben Pettet, Company Law (Longman Publishing, London, 2005) 15). Jin Zhu Yang, The Role Of Shareholders In Enforcing Directors Duties: A Comparative Study Of The UK And China: Part 1, 17 (11) I.C.C.L.R. 318-328 (2006) 16). Guy Nesbitt, Directors’ Duties under Common Law and Statute 825 Tax Journal 13-14 (2006) 17). Margarita Sweeney-Baird, The Role Of The Non-Executive Director In Modern Corporate Governance 27(3) Comp. Law. 67-81 (2006). Read More