Wading Through the Thicket, Stemming Abuses - Essay Example

Chapter I. Development of Corporate Governance: Wading Through the Thicket, Stemming Abuses 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. To quote Demotti1: 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. In a company, virtually all policy-making is left in the hands of the Board of Directors or on the majority shareholders. The definition of director given at section 741(1) of the Companies Act 1985 ‘includes any person occupying the position of director by whatever name called.  This definition can also be found in the Insolvency Act 1986 section 251 and the Company Directors Disqualification Act 1986 section 22, where it is extended to include shadow directors. 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. In theory, a director, holding as he does a position of trust, is a fiduciary of the corporationii. 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 favor of someone seeking to do business with the corporation. In many other cases, however, the line of demarcation between the fiduciary relationship and a director’s personal right is not easy to define. The law has attempted at least to lay down general rules of conduct and although these serve as guidelines for directors to follow, the determination as to whether in a given case the duty of loyalty has been violated has ultimately to be decided by the court on the case’s own merits. 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 Miller2 said: Shareholder disputes present one of the most prevalent and destructive problems encountered by the privately-owned business. Shareholder conflicts appear to be universal. Minority shareholder allegations against the majority reverberate in courtrooms throughout the world. Common accusations are that the majority has excluded the minority from active participation in the business or has mismanaged or misappropriated assets. Complaints that the majority has taken excessive remuneration or has failed to pay dividends cross geographical barriers. 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.3 This may take various forms – per diems, salaries and profit-sharing arrangements like bonuses, stock option plans, and the like. Executive compensation in the United Kingdom is typically comprised of the following elements: a base salary, an annual bonus element, and long term pay. Long term pay consists of share options and long-term incentive plans4. In other jurisdictions, as a general principle, directors as such are not entitled to compensation for performing services ordinarily attached to their office, unless the articles of association or the by-laws expressly so provide or a contract is expressly made in advance. In theory, compensation to executives and employees are incentives to greater efficiency. Since the corporation ultimately benefits by this increased efficiency, such forms of compensation would be intra vires, and the fixing of the amount thereof would usually be within the business judgment of the directors. However, 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, Gregg and Machin5: 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. Even where a link has been identified its magnitude seems to be extremely small. This has been widely interpreted as reflecting a misalignment of incentives between top directors and shareholders and, as such, providing little support for principal-agent models where the top executive acts as an agent for the owners of the company. It is simply impossible to talk about corporate governance without talking about shareholder remedies. Such body of legislation occupies a crucial position in Company Law. in cases of mismanagement where the wrongful acts are committed by the directors or trustees themselves, a stockholder or member may find that he has no redress because the former are vested by law with the right to decide whether or not the corporation should sue, and they will never be willing to sue themselves. The corporation would thus be helpless to seek remedy. Because of the frequent occurrence of such a situation, the common law gradually recognized the right of a stockholder to sue on behalf of the corporation in which eventually became known as a “derivative suit.” It has been proven to be an effective remedy of the minority against abuses of management and an instrument that affirms desirable norms in the corporate setting. Thus, an individual stockholder is permitted to institute a derivative suit on behalf of the corporation wherein he holds stock in order to protect or vindicate corporate rights, whenever officials of the corporation refuse to sue or are the ones to be sued or hold the control of the corporation. In such actions, the suing stockholder is regarded as the nominal party, with the corporation as the party in interest. Expounds Romano6: Shareholder litigation is accorded an important stopgap role in corporate law. Liability rules are thought to be called in play when the primary governance mechanisms – board of directors, executive compensation, and outside block ownership – fail in their monitoring efforts but the misconduct is not of sufficient magnitude to make a control change worthwhile. By imposing personal liability on corporate officers and directors for breach of the duties of care (negligence) and loyalty (conflict of interests), litigation is thought to align managers’ incentives with shareholders’ interests. Although there are many points regarding derivative suits that are still the subject of much conflict of opinions, there are crystallized rules are well settled and considered universal. First of all, the stockholder or member bringing the suit must have exhausted his remedies within the corporation; i.e., he has made a demand on the directors or trustees to sue and the latter have either failed or refused to do so7. This demand however is not necessary where it would be futile to make it, as where the majority of the directors or trustees are the very ones guilty of the wrong complained of. Secondly, the stockholder or member must have been one at the time the transaction or act complained of took place, or in the case of a stockholder, the shares must have devolved upon him since by operation of law, unless such transaction or act continues and is injurious to the stockholder.8 Thirdly, any benefit recovered by the stockholder or member as a result of the bringing of the derivative suit, whether by financial judgment, by judicial compromise, or by extra-judicial settlement, must be accounted for to the corporation, who is the real party in interest. Lastly, if the suit is successful, the plaintiff is entitled to reimbursement from the corporation for the reasonable expenses of litigation, including attorney’s fees.9 II. Influence of the Combined Code and other Codes of Practice The Combined Code on Corporate Governance lays out the benchmarks of good practice with respect to board composition, remuneration, accountability and shareholder relations. All companies that have been incorporated in the United Kingdom and listed on the Main Street of the London Stock Exchange have the obligation to disclose the ways in which they have conformed to and applied the Combined Code to their governance practices. According to the Financial Reporting Council, the main changes made to the 2003 Code were: to amend the existing restriction on the company Chairman serving on the remuneration committee to enable him or her to do so where considered independent on appointment as Chairman (although it is recommended that he or she should not also chair the committee); to provide a ‘vote withheld’ option on proxy appointment forms to enable shareholders to indicate if they have reservations on a resolution but do not wish to vote against. A ‘vote withheld’ is not a vote in law and is not counted in the calculation of the proportion of the votes for and against the resolution; and to recommend that companies publish on their website the details of proxies lodged at a general meeting where votes are taken on a show of hands. The Combined Code traces its roots to the Cadbury Report or the ‘Financial Aspects of Corporate Governance Committee’ led by Sir Adrian Cadbury. It “outlined a number of recommendations around the separation of the role of the chief executive and chairman, balanced composition of the board, selection processes for non-executive directors, transparency of financial reporting and the need for good internal controls.” This was followed by the Rutteman Report and the Greenbury Report, then by the Hampel Report which laid the ground for the Combined Code of 1998, which was superseded by the Combined Code of 2003. In order to better implement the Combined Code, the Turnbull Committee was created to draft the Turnbull guidance. There are several documented examples of corporate governance in companies. To quote from Corporate Governance Principles of Ford: A majority of the directors must be independent directors under the New York Stock Exchange (NYSE) Listed Company Rules or any other regulatory requirements, as such requirements may change from time to time…. To be considered independent under the NYSE Rules, the Board must determine that the director does not have any direct or any indirect material relationship with Ford. III. THE CURRENT COMPANIES BILL: Opening up New Horizons The Company Law Reform Bill received its second reading in the House of Lords on January 11, 2006 and, as stated by Lord Sainsbury, Parliamentary Under-Secretary of State at DTI, the purpose of the Bill is to “to constantly update company law in response to changes in the way companies do business”. According to Lord Sainsbury, the bill 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. Significantly and of most interest to legal theorists, the bill sets “a new procedure for bringing such an action which set down criteria for the court distilled from the Foss v Harbottle jurisprudence". It essentially expands the existing derivative action, and allows shareholders to sue the directors for a wider range of breaches, namely in respect of an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust. Another significant change is that a shareholder who has brought proceedings must apply to court for permission to continue the claim. The following criteria must be followed by the court in considering whether or not refuse permission are as follows: whether the applicant is acting in good faith; the importance a director promoting the success of the company would attach to continuing the claim; whether the conduct would be likely to be authorised or ratified by the company; whether the company has decided not to pursue the claim; and whether the applicant should pursue a remedy in his own right (ie under section 459 CA) instead of on the company’s behalf.  The bill also contains restrictive provisions on the issue of ratification by the majority. Members who are personally interested in the ratification or who stand to gain from it will not be allowed to vote, when such ratification involves a director’s negligence, default, breach of duty or breach of trust. The consequence of this is that it will now become easier for shareholders to obtain permission to continue a derivative action. If leave of court is granted, the company must reimburse the shareholder for the costs of litigation. Part 11 of this Bill is not without controversy. There are quarters that posit that the inclusion of “pure negligence” as a ground for a derivative suit constitutes an unreasonable expansion. Said Lord Hansard, “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.” By and large, however, there is more to be gained than lost by the developments ushered in through the Company Law Reform Bill. 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.10, 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 the Bill represents a new frontier that must be embraced, and not feared. References Barak, Aharon. “A Comparative Look at Protection of the Shareholders Interest: Variations on the Derivative Suit.” International and Comparative Law Quarterly, Vol. 20, No. 1971). pp. 22-57. Blake, A. and Bond, H., Company Law, London, Blackstone, (1993) 4th Ed. Boyle, A.J. Minority Shareholders’ Remedies. Cambridge University Press. 2002. Bourne, N., Essential Company Law, London, Cavendish, (1994). Bourne, N., Company Law, London, Cavendish, (1995). 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Grantham, Ross. “The Doctrinal Basis of the Rights of Company Shareholders.” The Cambridge Law Journal. Vol. 57 (1998). 554-588. Griffin, S. Company Law Fundamental Principles, 1996. 2nd edition. Pittman Publishing. Hannigan, B., Company Law, London, Butterworths, (1995). King, Mervyn; Roell, Ailsa; Kay, John; Wyplosz, Charles. “Insider Trading.” Economic Policy, Vol. 3, No. 6 (Apr., 1988), pp. 163-193. Mayson, S.W., French, D, & Ryan, C. Mayson, French and Ryan on Company Law. 1998, 15th ed., Blackstone Press, London. Miller, Sandra K. “How Should U.K. and U.S. Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct Be Reformed?” American Business Law Journal, Vol. 36. (1999) “Companies Law Reform Bill: An Overview.” Norton Rose. December 2005. August 2006.www.nortonrose.com Romano, Roberta. “The Shareholder Suit: Litigation without Foundation?” Journal of Law, Economics, & Organization, Vol. 7, No. 1 (Spring, 1991), pp. 55-87 Sealy, L., Cases and Materials in Company Law, London, Butterworths, (1992). Read More