The UK Corporate Governance System - Research Paper Example

Company Law In the UK, the corporate governance system is based on two concepts. First, the separation of powers and control in the corporation and second, the establishment of one tier board of non-executive directors. These two components are considered to be essential for an effective corporate governance system. The executive body will have to undertake two diverse functions, such as the general corporate functions and supervision of the functions. As such, it plays the role of the supreme executive body and the supervisory organ within the corporate entity;and these functions have to be carried out by two separate bodies (Wei 126). Thus, the one – tier executive board cannot perform two incompatible functions. In this structure, there is possibility of power being abused by the directors. This situation would lead to lack of accountability on part of the directors. These possibilities have been identified in the past. The disclosure system was established to overcome these problems and to promote accountability among directors. This system is concerned with the one – tier boards, with two functions. The UK has a highly efficient and mature stock exchange market, and it is mandatory for all the listed companies to operate in accordance with the disclosure rules (Wei 126). However, the disclosure system has been found to be inadequate, whilst dealing with the modern and complex systems of the present day companies. There are several possibilities of misusing the disclosure system, in order to mislead shareholders. The distribution of ownership does not hold out much benefit to individual shareholders, who will not be able to analyse the financial information of their companies. In the absence of such analysis, it is difficult to monitor the activities of the executive board. The recent developments concentrated on this aspect of monitoring the role and functions of auditors, non – executive directors and institutional investors (Wei 127). The UK adopted the concept of objective of companies in its Company Law. Section 172(1) of this Act establishes the objective of companies. A superficial examination of this section indicates that it undertakes a stakeholder approach. However, a closer examination discloses that this assumption is incorrect. This law stipulates that the actions of the directors of the company must be in the best interests of its shareholders (Keay 611). As such, this law merely requires the company directors to safeguard the interests of the shareholders, and it does not make them liable if they fail to consider the interests of the other constituents of the company. The various stakeholders have different interests, resulting in a conflict of interest. Thus, there should be a balancing approach to deal with conflicting interests. Moreover, stakeholders are not empowered to take any action against directors who fail to adequately safeguard their interests (Keay 611). Therefore, stakeholder value can be deemed to lack sufficient precision. The UK law introduces the Enlightened Shareholder Value Approach system in this regard. However, it does not provide any guidelines as to how the ESV system is to function. Moreover, stakeholders are not provided with the right of enforcement, in the event that Section 172(1) of the Act is infringed (Keay 611). Stakeholders cannot invoke legal proceedings, and this adverse situation creates legal problems. Section 172(1) influences the general duties of the directors of a company; and results in legal uncertainty, regarding their general duties. Apparently, it bestows widespread discretionary powers upon directors, in respect of the review of the six statutory factors. Nevertheless, company directors are required to accord sufficient importance to these factors, on account of the provisions of Section 471. This section pertains to the disclosure obligations of directors, regarding the business review section of their annual report. The experiences in this area reveal that some directors have exceeded the minimum statutory standards for environmental and social issues (Yeoh). This has proved to be beneficial to their corporate actions and strategies. As such, Section 172 introduced the concept of Enlightened Shareholder Value (ESV) system, which has generated considerable controversy. This Section came into force with effect from 1st October 2007. Prior to the introduction of the ESV approach, corporate directors were required to act in the best interests of their company. (Modernising UK Company Law). The new ESV approach requires the directors to act in the best interests of the company while taking in to consideration, the interests of the stakeholders, employees, suppliers, consumers and the environment. In this manner, a single duty towards the best interests of the shareholders has been stipulated. Accordingly, directors will be liable only to the company or its shareholders, whenever a breach of duty transpires and it can be demonstrated that the company had been put to loss, on account of such violation. This could prove to be irksome, as the directors would have to exercise considerable circumspection in their decision-making; and would have to record the details of their decisions, in order to protect themselves from legal proceedings (Modernising UK Company Law). Different theorists have put forward different definitions, regarding corporate governance. Zingales has stated that corporate governance is a set of restrictive procedures that deal with retrospective bargaining over the quasi-rents produced by the company. Shleifer and Vishny viewed corporate governance as the guarantee provided to outside investors, in respect of the funds invested by them in a company and protection for the returns from such investment (Gillan 382). Other experts have defined corporate governance as a comprehensive system of laws that govern the operations of a company. Corporate governance is a legal system that operates on the basis of the laws of the state, so as to supervise the activities of the insiders of the company and to protect the interests of the outsiders (Gillan 382). As such, corporate governance is a legal concept that protects the interests of outside investors, like shareholders and creditors of the company. It operates through the legal system of the state, and requires effective laws and their enforcement by the state. The reputation of companies plays a significant role in mobilising capital investments. However, an efficient legal system attracts more funds, as it guarantees the safety of the investment of outsiders (La Porta, Lopez-de-Silanes and Shleifer 4). This can be witnessed in some countries that have an effective legal system. The companies in these countries are able to raise more funds than the countries, whose legal system is ineffective. The laws of the state protect the rights and interests of shareholders and creditors, and outside investors who are vulnerable to expropriation. The employees and suppliers of companies are not at risk of being expropriated, because the companies themselves provide protection (La Porta, Lopez-de-Silanes and Shleifer 4). This is due to the fact that companies view their employees and suppliers as useful in the long term. Further research in this area established models of financial instruments based on the rights of the shareholders to evaluate the control over the company. Investors have rights and powers, and with this power, they can change the directors or compel the management to pay dividends. Investors have control over the functions of the company, because they invest the necessary capital. The decisions taken by the directors is invariably influenced by the investors, who can prevent the implementation of a decision or stop a scheme that provides monetary benefits to the inside investors (La Porta, Lopez-de-Silanes and Shleifer 5). Moreover, investors can sue the directors of the company for compensation, if their interests are affected by the acts of the latter. As such, they have the power to liquidate the firm. Furthermore, any change to the capital structure of the company would change the distribution of power between the insiders and the outsiders. (La Porta, Lopez-de-Silanes and Shleifer 5). In addition, such developments result in a change in the investment policies of the company. The expropriation of investors would adversely affect the ownership structure of the company, and controlling rights play a major role in the viability of a company. The rights of investors have to be adequately protected, and any possibility of expropriation of investors has to be prevented (La Porta, Lopez-de-Silanes and Shleifer 13). This prevents the exercise of control rights by insiders to expropriate outsider investors. In general, courts will not interfere with the decision-making process of directors, under normal conditions. Such intervention takes place, only when there is mala fide intent in the decisions of the directors. It has been suggested that instead of recording the various steps involved in arriving at a decision, the directors could engender a corporate culture that would adopt a holistic approach to the effect of their decisions (Modernising UK Company Law). Such freedom encourages directors to further their own interests, under the guise of a holistic approach. Conflict of interests creates financial diversification within financial institutions. Although such decisions are profitable for the companies, they fail to create shareholder wealth. Diversification does not create wealth; instead, it results in additional costs to the firm. Similarly, certain activities within the company create conflicts of interest, but these activities prove to be profitable only if the company can take advantage of them (Mehran and Stulz 274). Financial institutions can receive incentives from the activities that create conflicts of interests. However, they will have to make use of the information derived through these activities to make profits. Otherwise, interests of shareholders will be at stake. The English case law in this area established that directors were not obligated to consider the interests of creditors of the company. Lord Diplock’s ruling in the 1980 case of Lonrho v Shell further fortified this perception. It has become a custom for the courts to hold that the company laws do not impose a duty towards the creditors of the company, upon its directors, when the company is approaching insolvency (Tully 116). As such, directors are not under a direct duty towards creditors of the company. However, they are required to protect the interests of the creditors of the company. In such situations, the creditors can rely on the liquidator, who acts on behalf of the company. In Brady v Brady, Nourse LJ held that when the company was nearing insolvency or when it was doubtfully solvent, the company’s interests would be only that of the creditors. It was also opined that even if the company were to be solvent, priority had to be accorded to the interests of the creditor (Tully 117). This ruling once again established that the directors were under a fiduciary duty to protect the interests of the creditors, irrespective of the solvency or insolvency of the company. The entity with majority share holding exercises control over the activities of a company. Nevertheless, the courts have extended the connotation of control, in relation to the commission of fraud on the minority shareholders. In Prudential Assurance Co Ltd v Newman Industries Ltd, the chair and vice chair of the public company held a substantial portion of shareholding of a second company. However, they were the minority shareholders in that company (Prudential Assurance Co Ltd v Newman Industries Ltd (No 2)). Consequently, they made proposals to purchase the share capital of the second company, on the basis of the asset value of that second company. Thereafter, it was contended that the chair and vice chair had provided misleading information about the asset value of the second company to the general meeting that had approved the purchase (Kelly, Holmes and Hayward 357). The Prudential Assurance Co Ltd attempted to embark upon a derivative action, depending on the common law exceptions to the rule established in Foss v Harbottle. Specifically, this allows a minority shareholder to bring a claim on behalf of the company. Otherwise, the legitimate claimant, in any action against a company for wrongdoing, is the company, itself. Initially, the court held that although the chair and vice chair were minority shareholders, they had control over the information being provided to the board of directors, and the advisers and the general meeting of the company. As such, they could proceed on their action of purchasing the share capital of the second company. The directors of the company brought an appeal before the Court of Appeal, regarding the action of the chair and vice chair (Prudential Assurance Co Ltd v Newman Industries Ltd (No 2)). However, the Court of Appeal upheld the ruling of the lower court. In Re Uno, the court examined the application of the Company Directors Disqualification Act 1986. A group of two furniture companies were involved in this case. These companies had continued their business operations, despite facing drastic financial difficulties. At the same time, the directors of these companies had strived hard to find ways to save the businesses. One of the companies of this group, Uno raised working capital, by accepting deposits from customers. It promised its customers that it would complete their orders, well within the agreed upon time (Re Uno plc v Secretary of State for Trade and Industry v Gill). However, it was unable to continue and had to go in for liquidation. The directors were instructed to deposit the money taken from customers in a trust account, as this would safeguard the money of the customers. The directors decided not to deposit the money in such a trust account, and diverted these funds towards the day to day running of the business (Re Uno plc v Secretary of State for Trade and Industry v Gill). Some of the affected customers filed a petition with the Department of Trade and Industry seeking disqualification of the directors, on the basis of their allegedly unethical behaviour and their perceived lack of interest in safeguarding the interests of the customers of the company. However, the Department refused to comply with this supplication of the customers. The court held that in order to disqualify the directors, it would have to be established that the directors’ behaviour had been dishonest or that there had been an absence of commercial honesty (Re Uno plc v Secretary of State for Trade and Industry v Gill). In addition, the alleged behaviour should have been incompatible with the management of the company. The court was of the opinion that the directors had acted in the best interests of the company by pursuing realistic opportunities. As such, it was held that the company directors had made a genuine and honest attempt to salvage the company from the financial imbroglio and liquidation. Consequently, they were exonerated from the charge of having acted in an irresponsible manner and the subsequent failure of the business. In Heron International Ltd v Lord Grade, it was held that the directors of a company were under a fiduciary duty to protect the interests of shareholders, if there was a takeover bid against the company, by another company. This principle applies even when the activities of the company are aimed at protecting the shareholders indirectly. The courts do not allow a company and its directors to diverge from this duty of protecting shareholders. (Heron International Ltd v Grade). The objective of this duty is to provide protection to the interests of investors. The Court of Appeal in the Greenhalgh case, made it clear that shareholders could pursue their own interests at the time of voting. This ruling was important in the area of the voting rights of shareholders. However, it is not the case with majority shareholders. In their case, there are certain restrictions, regarding the manner in which they can utilise their voting powers (Greenhalgh v Arderne Cinemas Ltd). In Clemens v Clemens, a majority shareholder was prevented from employing her voting power, in a manner that would affect the interests of a minority shareholder. This case related to a company that was run by the members of a family, and this ruling is confined to solely such instance (Clemens v Clemens Brothers Ltd). It cannot be applied to cases, involving public companies. In Coleman v Myers, a son and father, who acted as the managing director and chairman of a company, run by their family, were deemed to owe a fiduciary duty to the shareholders. Moreover, in Gething v Kilner, Brightman J held that directors were under a duty to be honest towards their shareholders; whereby they were precluded from misleading them (Goulding 257). In Percival v Wright, it was argued that directors were trustees, whose duty was to safeguard the interests of the company and the shareholders. The directors of the company in question, had acquired shares from some shareholders, without disclosing that they were undertaking negotiations regarding these shares with a third party. These shares appreciated in value after their transfer by the shareholders, due to these negotiations (Goulding 256). It was the plea of these shareholders that the directors had acted with mala fide intent and that the share transfers were to be set aside. This was refuted by Justice Swinfen Eady, who held that the directors did not owe any fiduciary duty to the individual shareholders. The directors were required to act for the benefit of the company and to protect its interests(Goulding 256). They were not obliged to inform shareholders about the negotiations with third parties. In Allen v Hyatt, the directors of the company had negotiations with a third party that was desirous of amalgamating the company with another company. The directors approached the shareholders of the company and expressed their desire to purchase their shares, in order to negotiate with that third party and effect the amalgamation. These directors made a huge profit, from their negotiations with the third party. The Privy Council held that as the directors themselves had approached the shareholders, they had acted as agents of individual shareholders. Consequently, they were deemed to be trustees of the profit (Goulding 256). Hence, the individual shareholders should also have been benefited from the amalgamation. An incorporated company can mobilise large amounts of capital by bringing together a number of partners. A company’s capital mobilising ability will be enhanced by its incorporated status. As such, a straight partnership can motivate several investors to invest capital into it. However, this entails certain modifications, which will create a separate partner who differs from the company in which the capital is invested. This new partner will be created for the sole purpose of investing capital. Such partners are termed as silent or non-managing partners. There are certain rights and responsibilities inherent in co-partnership businesses, which will be transferred to the managing partners (Eeghen 45). As a result, the managing partners are exposed to high levels of risk and responsibility. Moreover, there are some limits on the capacity and size of partnerships. In case of incorporated corporations, there are no limits, regarding the size of business and the risks undertaken. Thus, corporations are considered to be superior to partnerships and they can mobilise huge amounts of capital. In partnerships, the liability of non-managing partners is limited, and their legal status is akin to that of the shareholders of a corporation. Furthermore, non-managing partners do not have any right to consultation for ownership transfer of the assets of the partnership (Eeghen 46). In general, straight and unqualified partnerships evolve into corporations. However, there are differences between partnerships and corporations. The fundamental difference is that there will be no managing shareholders in corporations. All corporate shareholders are non-managing partners (Eeghen 46). Hence, the incorporation of a private firm should be permitted, only if the public interest is promoted within the public domain. In the absence of such qualities, incorporation should not be permitted. From the foregoing discussion, it is evident that the corporate law’s attempt to control conflict of interest among corporate constituencies is far from satisfactory. A perusal of the case law, shows that company directors are in general, allowed considerable leeway, Vis – a – Vis the decisions they take in their official capacity. On many an occasion, company directors have benefitted to a significant extent, without extending such benefit to the shareholders. Albeit, the courts have passed strictures against such directors; nevertheless, in the majority of the cases, there has been little if any interference with their activities. Moreover, the concept of ESV promotes the interests of the directors, while failing to protect the interests of the stakeholders. Works Cited Allen v Hyatt. No. 30 TLR 444. 1914. Clemens v Clemens Brothers Ltd. No. 2 All ER 268. 1976. Coleman v Myers. No. 2 NZLR 225. 1977. Eeghen, Piet-Hein Van. "The Corporation at issue, Part II: A Critique of Robert Hessen's In Defense of the Corporation and Proposed Conditions for Private Incorporation." Journal of Libertarian Studies (2005): 19.4, 37 – 57. —. The Corporation at issue, Part II: A Critique of Robert Hessen's In Defense of the Corporation and Proposed Conditions for Private Incorporation. 2005. 9 February 2010 . Foss v Harbottle. No. 37 ER 189. 1843. Gething v Kilner. No. 1 All ER 1166. 1972. Gillan, Stuart L. "Recent Developments in Corporate Governance: An Overview." Journal of Corporate Finance (June 2006): Volume 12, Issue 3, P382. Goulding, Simon. Company Law. Routledge, 1999. Greenhalgh v Arderne Cinemas Ltd. No. 2 All ER 1120. 1950. Heron International Ltd v Grade. No. BCLC 244. 1983. Keay, Andrew. "Tackling the Issue of the Corporate Objective: An Analysis of the United Kingdom's 'Enlightened Shareholder Value Approach'." The Sydney Law Review (2007): 29: 577 – 612. Kelly, David, Ann E.M Holmes and Ruth Hayward. Business Law. Routledge Cavendish, 2005. La Porta, Rafael, et al. "Investor protection and corporate governance." Journal of Financial Economics (2000): Volume 58, Issues 1-2, Pages 3-27. Mehran, Hamid and René M. Stulz. "The economics of conflicts of interest in financial institutions." Journal of Financial Economics (August 2007): Volume 85, Issue 2, Pages 267-296. Modernising UK Company Law. 6 February 2010 . Percival v Wright. No. 2 Ch 421. 1902. Prudential Assurance Co Ltd v Newman Industries Ltd (No 2). No. 2 All ER 841. 1980. Re Uno plc v Secretary of State for Trade and Industry v Gill. No. EWHC 933. 2004. Tully, Stephen. Research Handbook on Corporate Legal Responsibility. Edward Elgar Publishing, 2007, P117. Wei, Yuwa. Comparative corporate governance: a Chinese perspective. Volume 3 of Global trade and finance series, P126 . Yeoh, Peter. "The direction and control of corporations: law or strategy?" Managerial Law (2007): 37-47; Vol. 49, Issue 1/2. Read More