Effectiveness of UK Corporate Law in Preventing Corporate Greed

1. Introduction

The greedy shareholder is often anthropomorphised to that of a pig rolling round in mud; stereotypically typified as “the minister of religion [or] the shopkeepers widow… [who] wants 7 or 8 per cent and thinks that 10 or 12 per cent is ascertainable, believing this to be ‘tolerably safe’.”[1] Many observers of large public corporations in the United Kingdom[2] believe this type of shareholder to be the root cause of corporate failure as a result of their perception that their own personal wealth and status is justifiably more important than that of the interests of the company’s other stakeholders. This criticism of shareholder primacy theory has been supported by the developments in corporate law and governance since major scandals at public companies limited by shares in the 1990s that came about as of corporate greed.

But what is corporate greed? Corporate greed has many varying definitions dependent on the author and even then, lacks clarity. However, in order to create a solid base for the purposes of this dissertation paper a definition will be constructed by breaking the term down into both “corporate” and “greed”.  The adjective “corporate” names any attribute relating to a company or group.[3] “Greed is an overwhelming urge to have more of something, usually more than you really need.”[4] A social construct that has existed throughout human history.[5] Together, the terms can relate to a company, in its own right as a separate legal entity, or indeed the directors and shareholders who run and own it, respectively.

Shareholder primacy (an extreme of the more commonly known shareholder theory, often referred to as shareholder supremacy) and stakeholder theory are the two commonly referred to, underlying theories behind the implementation, development and existence of corporate law, corporate governance and corporate social responsibility in the United Kingdom. This dissertation paper aims to analyse the effectiveness of UK corporate law and governance in preventing directors, institutional investors and shareholders from pursuing their own interests to personal financial gain, as a result of corporate greed. To do so, this paper will first discuss the rise and fall of shareholder supremacy theory and how this saw developments in UK law and governance moving away from the underpinning of shareholder theory, to the ‘modern day’ stakeholder theory. The main discussion presented by this dissertation is whether the above-mentioned reform has provided enough transparency and accountability to combat corporate greed.

dissertation is whether the developments in UK corporate law and governance have allowed for the balance of the shareholder’s perceived ‘right’ to personal financial gain against the wider stakeholder interests. This dissertation paper will summarise as to whether the developments discussed have effectively prevented corporate failures, particularly as a result of corporate greed. Recommendations will be given as to the way in which corporate law and governance may need to be developed. Evidence will be drawn from academic discussion regarding corporate governance reform and S.170-177 Companies Act 2006 – which are the key provisions highlighting the statutory duties imposed on directors. It is important at this stage to note that there is no globally universal, ‘one-size-fits-all’ definition for what corporate governance is.[6] Over the years there have been developments in theories surrounding corporate governance which have changed the way in which it has been defined and applied to corporate dealings. The succeeding paragraph focuses on the two main theories of UK Corporate Governance – shareholder value and stakeholder value theory, and the developments of the UK Corporate Governance Code.

Corporate Law and Governance in the United Kingdom

2.1 The Origins of Corporate Law and Governance

The introduction of limited liability in the UK back in 1855 made it possible for pools of entrepreneurs and investors to collaborate under a separate legal entity with a view to raising capital, without harming their individual personal wealth. Most operate under a public company limited by shares due to its enhanced legal protection and ability to sell shares to raise further capital. A public company limited by shares, or a company as referred to herein unless explicitly stated otherwise, is a legal entity that is separate and distinct from that of its owner(s).[7] In order to create such a separate legal entity, a company must be incorporated at Companies House.[8] This requires there to be at least two directors, depending on circumstances[9], who are appointed to control and govern the company; and at least one shareholder who provides the resources and/or financial backing for the company. This sees a separation between the ownership and control of the company and has been identified by many academics as the birthplace for the concept of ‘Corporate Governance’[10] (although the term ‘corporate governance’ was not explicitly used)[11] due to the need to control the differing interests of the directors/managers and shareholders.

Traditionally, the structure of corporate law and governance in the UK has been based on shareholder value theory – a theory in which a corporation is managed and operated to provide financial gain for its shareholders and investors. “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it… engages in open and free competition without deception or fraud”. [12] This quote by Milton Friedman, the original proposer of shareholder value theory, highlights the view that the predominant aim of corporate law and governance should be profit maximisation. For many decades, profit maximisation for shareholder gain has indeed been the primary and sole objective of many companies.[13]

The shareholder value approach is supported by the idea of agency theory. This is the view that the shareholders are the owners and economic engine of the company to whom the directors and management must be responsible. This ideology was inexplicitly referred to by Milton Friedman, as quoted above, but was brought to light by Jensen and Meckling in an academic paper describing companies as “legal fictions” in which shareholders are principals and directors are agents, and that any manager or director who pursued goals other than those to maximise shareholder wealth were reducing social good.[14] Keay explains that as the shareholders will be the ones to bear the loss should the company suffer or become insolvent, they have the right to control the company above and beyond those rights or interests of other stakeholders.[15] It is believed also, by many supporters of this theory, that by increasing the value and wealth of the shareholders, value and wealth will also be created for other stakeholders, including the directors and managers. This has been labelled as the ‘invisible hand’ concept, where a shareholder or investor ‘endeavours to employ his capital so that its produce may be of greatest value and in the process… [promotes] the interest of society indirectly’.[16] On the surface, this theory seemed to best benefit all stakeholders of a company, but predominantly the shareholders.

2.2 Exploitation of Shareholder Supremacy Theory

Backing and support from other academics by the early 1990s, however, saw the shareholder value ideology soon gave rise to a more extreme form of shareholder theory known as shareholder primacy – a theory in which the shareholders are held ‘supreme’ over any other stakeholders and the directors and management must be solely responsible to their shareholders and investors. Alongside support from CEOs, journalists and academics, shareholder primacy was supported in the 1990s and early 2000s particularly by corporate raiders and activist hedge funds, otherwise known as institutional investors. Institutional investors buy and sell large blocks of shares in public listed companies in order to make a profit for themselves and their clients. These groups would also be seen to pressurise the board of directors to remove money from the company and deposit it in to the personal pocket of the institutional investor. The justification given to the directors for doing so was that of a shareholder primacy rhetoric – the shareholders are held ‘supreme’ over any other stakeholders and the directors must be solely responsible to them. It was presented that any protest from the board was a refusal to ‘unlock shareholder value’.[17] After money was received, shares were sold and the next company was targeted.[18] By forcing the board of directors to present them with a financial return on their investment, companies targeted by the institutional investors saw increases in debts and in some instances parts of the company were sold to meet the demand of the institutional investor shareholders. This flaw in shareholder supremacy theory saw the shareholder get richer, at the expense of others who held interests in the company such as the employees, customers and wider stakeholders – including the directors.

2.3 Corporate Scandal as a result of Shareholder Supremacy Theory

As a result of shareholder primacy being entrenched as the way in which public companies should be operated, shareholders had more influence over the board of directors than at any other given point in business history. However, at the same time as the shareholder supremacy theory mentioned above was allowing institutional investors to secretly line their own pockets at the expense of a company, the theory was also allowing directors and executive officers to do exactly the same. Making headlines in the UK were the major scandals at Polly Peck and BCCI, among many. These scandals saw the Chief Executive Officers defraud their companies as a result of their own personal greed, leading to there being a call for major corporate governance reform in the United Kingdom.

2.2.1 Polly Peck International (1990)

Polly Peck was a small, family run textile and fashion house that was opened in London in the 1940s. By the end of the 1970s the fashion house was struggling and 58% of the shares were bought by Asil Nadir – who became Chief Executive in July 1980. Within ten years of office, Nadir led the diversification of Polly Peck into production of computer and electrical components, ownership of Turkish newspapers, hotels and banks. The company was publicly listed on the FTSE 100 Index and Nadir was said at this point to be worth £200 million. The management of Polly Peck relied heavily on Nadir’s intuition, skills and plentiful contacts to maintain its market dominance and substantially high share price.

Uncertainty remained around the suspicious reliance of Polly Peck on the Middle Eastern and Turkish markets. It was said that when criticism came from the Financial Times in 1983, Polly Peck lost one quarter of its share value within twenty minutes.[19] With rumours flying, the Serious Fraud Office (SFO) led an inquiry into the trading practices and accounting records of Polly Peck, only to uncover one of the largest corporate scandals in UK history. Nadir had bled the company of £141 million, paid out in 60 separate transactions, in the lead up to its collapse. Many of the company’s assets were held in his name and it was believed that the shareholder supremacy rhetoric quoted in the above chapter was used to pacify any resentment to his actions.

Off the back of the SFO investigation, a raid was carried out of the South Audley Management company, the company that controlled the interests of Nadir and his family, which sent share prices of Polly Peck into free fall. On the 25^th September 1990, Polly Peck was placed into administration. The company collapsed and charges were brought against Nadir for 70 counts of false accounting and fraud. In April 2016, Asil Nadir returned to a “hero’s welcome” in Cyprus after his release from UK prison on his way to serve the rest of his ten year prison sentence in Turkey for cheating investors out of millions.[20]
 

2.2.2 Bank of Credit and Commerce International [BCCI] (1991)

“It took 21 years and $656m (£415m) of fees paid to two firms of lawyers and accountants but on [the 10^th May 2012] the files were finally closed on the banking scandal that was the Bank of Credit and Commerce International. It ranged from arms trafficking to prostitution and ended with a $20bn collapse.”[21]

In 1991 BCCI went bust owing in excess of £20bn to its creditors revealing widespread corruption, money laundering and secret activities. The scandal that unfolded after the bank’s collapse is still ranked as one of the biggest banking scandals of all time. BCCI was investigated by financial and intelligence agencies globally between 1988 and 1990 due to concerns on its poor regulation. Investigations revealed that the company was involved in large scale money laundering crimes and involvement in other illegal activities such as arms trafficking and the supply of illegal substances. The corporate affairs of BCCI were kept masked from global governments and regulators due to the sheer complexity of its corporate structure and accounting practices. Managers at BCCI were sophisticated international bankers whose objectives were to promote the wealth of the shareholders, whilst at the same time, allegedly, keeping the ways in which they did so a secret by avoiding detection. The 25 branches of BCCI in the UK were closed by Bank of England officials in July 1991.

The above-mentioned instances were just two of many where it was discovered that the CEOs were committing accounting fraud during the 1990s and 2000s in the UK. Following the unearthing of such scandals, there was a drive and emphasis to ensure UK company law reforms and developments of the UK corporate governance code were undertaken. Scandals of large corporations at this time were also apparent in the US (Enron and Tyco International), Canada and continental Europe. In the above case examples, it was not the presence of institutional investor greed that caused the failure of the company – but rather the greed of the directors and managers acting in their own interests and defying their duties to shareholders. Shareholder supremacy theory allowed for directors to use the primacy rhetoric that the shareholders are held ‘supreme’ over any other stakeholders and that the directors must be solely responsible to them to hide their activity from any outside pressures.

It would be unfair to attribute the cause of the above-mentioned damage and corporate scandals solely to that of shareholder supremacy theory, however, it is perceived by many outsiders to be a major contributing factor. A causal, common link can be seen between the damage caused to companies by institutional investors, as a result of shareholder greed, and the corporate collapses of other companies, caused from executive greed, as being relative to the companies in the 1990s as having weak internal controls. This is what ultimately led to opportunistic directors, management and shareholders being able to exploit their respective company for their own personal gain – as seen above.

As a result of the global corporate scandals and damage caused by institutional investor to valid businesses, it was evident that there was need for urgent reform of corporate governance on both national and international levels to prevent corporate scandals resulting from corporate greed. The reform and codification of corporate law and governance led to a move away from shareholder supremacy theory, as explored below, to the more realistic stakeholder theory in order to improve transparency and accountability of public listed organisations.The scandals and exploitations above paved the way for the introduction of stakeholder theory; a theory that articulates a director’s duty is to balance the shareholders’ financial interests against the interests of other stakeholders, such as customers and employees, even if it reduces shareholder dividends.[22]

1. Developments and Codification of Company Law and Corporate Governance in the United Kingdom

This section, broken down into two sub-sections, will in the first instance discuss the developments in corporate governance which came about after the exploitation and collapse of the major companies mentioned above, and others, in the 1990s. Analysis will be made as to how each report, committee or code of corporate governance sees a move away from shareholder value and supremacy theory to a more transparent and accountable approach – otherwise known as stakeholder theory. The second subsection will discuss how the developments in corporate governance led to a revision in the Companies Act, again following a more stakeholder orientated approach. Before exploring the developments of law and governance it is important to identify what stakeholder theory is.

3.1 Stakeholder Value Theory

Like the definitions of ‘Corporate Governance’ and ‘Shareholder Theory’, stakeholder theory does not have a one-size-fits-all definition. Stakeholder theory was first proposed by Freeman, and outlines how directors and management can satisfy the interests of stakeholders in a business. Freeman’s broad definition of a stakeholder is “any group or individual who can affect or who is affected by the achievement of the organisation’s objectives”.[23] This definition has since been narrowed down to mean a person or group that either have or at least claim ownership, rights, or interests in a company and its past, present or future actions.[24] Stakeholder theory sees the directors and management accountable to parties other than the shareholders: primary and secondary stakeholders. Primary stakeholders are those who without their support and contributions the company may cease to exist.[25] This would include the shareholders, employees and customers for example. Secondary stakeholders are those groups that influence or affect, or are influenced or affected by, the company and its operations. This would include the local community and government for example. Stakeholder theory encompasses the shareholder value theory in as much as shareholders are one of the stakeholder groups whose interests are considered, but does not go as far as shareholder supremacy theory holding the shareholders to be supreme and the directors their agents (to whom they are solely accountable). Stakeholder theory is of the opinion that any group has contributed to the success of the company should have the interests recognized.[26] By giving weighting to the interests of those stakeholders, the theory aims to broaden accountability and transparency.The developments as to how stakeholder theory moved away from this viewpoint are explored in the following chapters.

3.2 The Birth of Corporate Governance Reform (Cadbury Report)

In the UK, the establishment of the Cadbury Committee[27] in 1992 was the first stage towards reforming corporate governance practices since the corporate accounting and fraud scandals. The term ‘Corporate Governance’ was defined in the first UK corporate governance report of the Cadbury committee as “the system by which companies are directed and controlled”; going on to explain that it is a shareholder’s role to appoint directors and auditors to ensure an appropriate governance structure, with said directors implementing and responsible for the governance of their company.[28] The committee published a report detailing general rules for best practice in corporate governance, such as: structure of the board of directors; the importance, effectiveness and value of auditors; and the role of institutional investors (such as Asil Nadir, mentioned above).[29]

The ‘best practice’ principles outlined by the report for the financial aspects of corporate governance were not only adopted in the UK but in subsequent countries, who incorporated some or all of the code into their national corporate governance codes. Support was immediately shown for the findings of the Cadbury report in the UK by the London Stock Exchange who incorporated the findings into the rules and requirements for their listings. From this point, to the present day, companies listed on the London Stock Exchange have to adhere to the code or explain to their shareholders why the company does not comply. This is known as the ‘comply or explain’ regulatory approach and aims to create a more transparent and accountable company for the benefit of society.

A main focus of the report, as a result of the earlier mentioned scandals, was to increase the accountability of management and directors to the shareholders of the company. It is now best practice for publicly listed companies to establish an audit committee with at least three independent directors, or explain why they haven’t. The audit committee sits as part of a company’s board of directors and has the sole responsibility for overseeing the financial, accounting and governance disclosures of the company. Internal audits serve a vital purpose and important role in strengthening trust and confidence between the shareholders and directors/managers regarding the accountability for financial aspects of the business. Implementation of an audit committee sees the first move away from shareholder supremacy theory and its ideology that the directors and management must be solely responsible to the shareholders. The directors now find themselves in a position where they are able to be held accountable for their actions by those on the audit committee.

3.2.1 Greenbury Report[30]

Set up by the Confederation of British Industry in 1994, the Greenbury Committee responded to increasing concerns regarding the seemingly excessive bonuses of senior executive officers. Extending on the discussions of the Cadbury report, the conclusion of the Greenbury report was that there needed to be an emphasis on strengthening the role of non-executive directors and that the remuneration committee should be completely independent. This differs slightly from the Cadbury report recommendation of three independent non-executive directors on the remuneration committee. A non-executive director is not involved in the day to day management of the company but is involved in the implementation of policies. They act independently from the executive directors on the board and challenge the performance of the company, often considering the viewpoints of external stakeholders. Having a remuneration committee made solely of non-executive directors could be seen as a definitive move away from shareholder theory in as much as the executive directors would be forced to somewhat consider the interest of those that the non-executive directors represent, in fear of reduced remuneration.

The Greenbury report in its codes of best practice proposed that “the performance-related elements of remuneration should be designed to align the interests of directors and shareholders and to give directors keen incentives to perform at the highest levels”.[31] The report goes on to show support for the idea that remuneration policies in UK companies should be linked to industrial performance in order to motivate directors to achieve the company’s strategic goals.[32] The recommendations of the report were again suggested on a ‘comply or explain bases’ where listed companies need to explain to the shareholders the reasons for not complying with the report recommendations.

Suggesting that director remuneration should be linked to industrial performance in order to motivate the directors to achieve the company’s strategic goals sees a move away from shareholder theory. By having to compete with other companies of the same industry in order to benefit from larger bonuses, directors are incentivised to look towards other stakeholders interests, for example the company’s competitors and customers, in order to benefit personally. This sees that although under the recommendations of the report their interests are aligned to the shareholders interest in a personal financial gain, they must show consideration and accountability to the industry, competitors and customers, amongst others in order to promote a successful company and increase industrial performance.

3.2.2 Hampel Report[33]

As a result of recommendations in the Cadbury and Greenbury report, Sir Ron Hampel chaired a committee responsible for reporting on the success rate of public listed companies, implementing the recommendations of both reports and their good practices of corporate governance. The Hampel report was published in 1998 and gave critique in four areas: role of the board; directors’ remuneration; the role of shareholders; and accountability and audit. The report supported the findings of the two previous reports.

The report went on to consider the performance of the company as more than the corporate governance defined in the past two reports, referring to the transparency and accountability of its operation.[34] Recommendations were made in the report that the directors should evaluate and review the effectiveness of all internal controls as well as the financial controls suggest by the previous reports.[35] By looking at internal controls such as business risk assessment and response, financial management, compliance with laws and regulations and the safeguarding of assets, as suggested by the report, there is a drive to increase the internal accountability. This again sees corporate governance best practice move away from shareholder theory in as much as there is not room for the secrecy of internal process as seen in 1990s corporate scandals (discussed in Chapter 2.2) due to the push for transparency and accountability across the company – and not just in relation to the financial aspects.

3.2.3 Combined Codes[36]

The combined codes saw consolidation of the previous three reports, broken down into two sections: the first aimed at public listed companies; and the second at institutional investors. The combined codes built on the transparency principle seen in the Hampel report and suggested that a balanced board of directors, in terms of non-executive and executive directors in the board, should be introduced so that no one individual could dominate the decisions of the board. As explained earlier, the non-executive directors’ role is to challenge the actions of the board and represent external stakeholder views on the decisions and policies that the company may want to implement. Their existence in the board shows the accountability of directors is also to those other than the shareholders, highlighting a more stakeholder theory orientated approach to corporate governance by this point of codification.

3.2.4 Higgs Report[37]

The Higgs report followed the collapse of Enron and WorldCom in 2001 and attempted to restore shareholder confidence by creating a more effective corporate governance system based on the previous reports.[38] The focus of the committee in this instance was on director independence; the effectiveness of non-executive directors, and their remuneration; and the relationship between directors and shareholders.  Derek Higgs, chair of the committee who produced the report, blamed the corporate scandals of the 1990s on the lack of effective corporate governance; particularly the conflicts of interest between the board and the shareholders and also the lack of an independent board. Higgs made several recommendations for reform off the back of this, including separation between the role of chairman and CEO.

The board of directors are responsible for monitoring the operations of the company and ensuring that the business is being run in line with the strategic goals set by the shareholders. Having the CEO and Chairman as the same person within a company, the opportunity exists for abuse of position due to ‘self-monitoring’. If the board is led by an independent chairman, they are more likely able to identify and correct areas where the company is not following the strategic goals. This supports the ideology that there should be a complete separation in the ownership and control of the company whether corporate governance be shareholder or stakeholder theory based. The recommendation for separation of ownership and control is still apparent today, and is the reason for needing strong corporate governance regulation.

3.2.5 Smith Report[39]

Adding to the findings of the Higgs report, Smith suggested that the corporate failures in the US were also as a result of conflicts of interest, combined with the role of the auditors and their relationship with the directors. The report brought about changes to the combined codes of corporate governance, mentioned earlier, which became applicable to all companies listed at the time on the London Stock Exchange. The report made clear that ‘while all directors have a duty to act in the interests of the company, the audit committee has a particular role, acting independently from the executive, to ensure that the interests of shareholders are properly protected in relation to financial reporting and internal control’.[40] Smith suggested that any conflicts of interest between the board and audit committee be reported to the shareholders. With the audit committee being able to approach the shareholders with any issues arising, the directors are held accountable for the accuracy of their financial reporting and actions; thus reducing the likelihood of illegal activity or goings-on that is not in the interests of the business, its shareholders or the parties represented by the audit committee (as mentioned earlier). This again supports the assertion that by separating the audit committee from the board of directors, accountability is increased to beyond just the shareholders.

3.2.6 Combined Codes of Corporate Governance[41]

The Combined Codes of Corporate Governance revised in 2004 was the first update to the 1998 codes mentioned in Paragraph 3.2.3 since the discussions that had taken place in various reports succeeding its enactment. The revised codes addressed the collective responsibility and accountability of the board that had been discussed in the interim reports but not explicitly stated in the 1998 codes. It was from this point that the discussions of the reports above were codified. In the same way as the 1998 report, the 2004 revision was split in to two parts: the first regarding the board of directors and its effectiveness; and the second regarding the institutional shareholders.

The revised codes provided clarity over the discussions in the previous reports regarding the role of the audit committee and their relationship with the board of directors. The code clarified that the duties of the audit committee are to: monitor the effectiveness of financial statements; review effectiveness of internal controls; and monitor external audits. “The modern audit committee forms an integral part of the governance structures of the board and can be seen to act as the ‘financial guard dog’ of the shareholders specifically and of stakeholders at large.”[42] Having a functional audit committee strengthens the internal controls of the company whilst simultaneously increasing the reliability of the board of directors. The codes confirmed that the role of the board and any subcommittees (such as the remuneration and audit committees) are central to good corporate governance.

3.2.7 Combined Codes of Corporate Governance revisions (up to 2016)

Further to the 2004 Combined Codes of Corporate Governance revisions (and the Companies Act 2006, discussed in the succeeding chapter) further reform was made. This followed on from the 2007 collapses of Northern Rock in the UK and Lehman Brothers in the US, combined with the financial crisis of 2008. With such collapses having a major effect on the UK and US economy there was increased demand for more transparent and strict rules in corporate governance, particularly regarding the board of directors. The UK Corporate Governance Code of 2010[43] was released to replace the previous codes and acted upon this need.

The 2010 reformed codes (paired with further recommendations from the Financial Reporting Council in 2012) followed two main recommendations: firstly, that companies should be following the ‘spirit’ of the code, rather than just the black and white text; and secondly, to improve the interaction between the shareholders and directors to enhance shareholder influence. Further minor recommendations were made in subsequent reports and reissues of the corporate governance code up and until the point of the release of most recent code in 2016. The UK Corporate Governance Code 2016 and its provisions will be discussed in more depth in Chapter 4 when assessing the codes success in balancing shareholder and stakeholder interests.

The United Kingdom’s system of corporate governance is now seen as being a world leader in the regulation of public listed company’s compliance with corporate governance; specifically, when it comes to the five explicit sections of the code: leadership, effectiveness, accountability, remuneration and relations with shareholders.[44]

3.3 Companies Act 2006[45]

It is important when discussing corporate governance reform to also look at company law, as both the statutory legislation of company law and the ‘comply or explain’ approach to corporate governance work hand in hand to govern public listed companies in the UK. In March 1998, the Department of Trade and Industry launched a review of company law. The review referred to the recommendations made in the Hampel report, mentioned above, regarding the structure of corporate governance. The Hampel report highlighted that corporate governance needed to refer to more than just financial goals, as this prioritises the interests of the shareholders, and instead more consideration needed to be given to all internal controls in order to account for those with wider interests in the company, promote business prosperity, and reduce scandal.[46] The Companies Act 2006, a revision of the 1985 act[47], brought significant change to the provisions relating to directors, shareholder and auditors following the reform in corporate governance. Complete enactment of the act took place in 2009, after a three year grace period  was given to companies to prepare for the significant changes.[48] These provisions will be analysed in the following sub-section.

3.3.1 Directors Duties

A significant part of the company law reform in 2006 was that director’s duties and responsibilities were codified. One aspect in particular that this gave rise to was consideration as to the meaning of the phrase ‘in the interest of the company’ that had originally led to the dispute over ‘who is the company?’ and indeed whether corporate governance was meant to be shareholder or stakeholder theory orientated. The Companies Act 2006, influenced by the Company Law Group Steering Committee[49], held that the directors are under a duty to consider the interests of the wider stakeholders when undertaking their duty towards the company. This is codified in Section 172 of the Companies Act 2006.

Section 172 of the Companies Act 2006 states that “a director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard” to six listed criteria.[50] Although the act specifically refers to employees[51], suppliers, customers and others[52] there is no objective standard to measure the ‘success of the company for the benefit of its members as a whole’. Guidance issued on Key Clauses in the Company Law Reform Bill states that:

“the decisions as to what will promote success, and what constitutes such success, is one for the directors’ good faith judgement. This ensures that the business decisions on, for example, strategy and tactics are for the directors, and not subject to the decisions by the courts, subject to good faith”[53]

Section 172(1) formally obliges directors to consider stakeholder interests during the decision-making process to be considered in so far as to ‘promote the success of the company for the benefit of its members’.[54] The decision as to what is regarded as ‘good faith’ and what constitutes the success of the company, as stated in the above guidance quote and Companies Act, is a decision for the collective board of directors. This sees a move away from the previous view of only acknowledging the interests of the shareholders.

Section 173 of the Companies Act 2006 requires the director to exercise independent judgement, with section 174 going on to require the director to exercise reasonable care, skill and diligence. The test under section 174 is objective, posing the question “would an intelligent and honest man in the position of the director, in the exact circumstances, have done the same thing?”. This objective test is taken from common law, (‘reasonable person test’) and is used in the codified legislation to assess reasonable care, skill and diligence to prevent directors from proclaiming that they thought what they had done was appropriate in the circumstances.[55] Imposing these duties on directors sees a move away from shareholder theory in as much as directors are now under a fiduciary duty to independently exercise their reasonable care, skill and diligence when it comes to promoting the success of the company for the benefit of its members. These duties require the directors to act of their own accord rather than as an agent of the shareholders.

3.3.2 Shareholder Provisions

A major shareholder may seek to control other shareholders and by doing so become ‘protected’ from the other shareholders and market pressures, giving rise to what is known as ‘entrenchment’.[56] Entrenchment allows the controlling shareholder to escape the scrutiny of other shareholders due to the controlling shareholders position of power. Once in such a position of power, a major or controlling shareholder imposes their viewpoint onto others; in extreme circumstances this may lead to value-distorting decisions which may affect the prosperity or operation of the business. Under section 22(2) of the Companies Act 2006, companies are only able to adopt entrenchment provisions in their articles on formation, or, if all the shareholders agree to an amendment to the articles. The implication of Section 22 is that controlling shareholders are no longer able to entrench their own interests above the other shareholders. This sees a more stakeholder theory orientated approach to company legislation in as much as it removes the ability of a controlling shareholder to be able to ‘self-protect’ against external company pressures with support of other shareholders.

A misinterpretation of the definition of shareholder theory saw some company directors commit breaches of duty or negligent acts in order to make a profit for the shareholders. However, as outlined earlier, the theory does not mean management teams are to do anything they can to make profit; Friedman’s original definition clearly defines the obligation of managers and directors to increase profits only through “legal nondeceptive means”.[57] In cases such as that of Polly Peck and BCCI, it would not be uncommon for the shareholders to dictate the actions of a director, albeit a breach of duty or negligent to do such activity, and then ratify their behaviour in order to benefit personally. Section 239 of the Companies Act 2006 allows the shareholder to ratify a directors’ behaviour but this is subject, however, to ordinary resolution and requires the votes connected to the director or their action(s) to be disregarded when considering whether such ordinary resolution has been met. This again prevents a controlling shareholder dictating how the company is managed, and instead gives light to the director to consider the interests of the wider stakeholder.

Section 303 of the Companies Act 2006 was amended after its enactment by the Companies (Shareholders’ Rights) Regulation 2009[58], which permits shareholder holding more than 5% of the voting rights to be able to call general meetings in all circumstances. Prior to this legislative change, a shareholder needed to hold more than 10% of the voting share. It may be assumed that the lowering of the required shares a shareholder needs to call a general meeting is in line with providing protection to the voices of minority shareholders. By lowering the required shares needed, protection is awarded to minority shareholders as they are able to call general meetings in order to voice their concerns. The previous threshold of 10% may have seen many minority shareholders not able to act upon any discrepancies they were facing. This reform of the Companies Act 2006 sees a move to a more stakeholder inclusive approach, whereas before the major shareholder opinions were more apparent.

3.3.3 Auditor Provisions

As mentioned previously when discussing the introduction of an audit committee under corporate governance reform, the existence of an internal audit committee in itself sees the directors accountable to internal auditors – a move in itself away from shareholder theory. The Companies Act goes one step further and under Section 475(1) of the act, a company’s annual accounts must be audited in line with Part 16 of the act, unless they fall into one of the exclusions. The audit committee have a responsibility for making a recommendation to the board of directors on the appointment, reappointment and removal of the external auditor but ultimately the decision lies with the directors.[59] External auditors are completely independent to the company being audited, so the fact that they are appointed by the directors does not allow room for coercion in auditing. The role of the external auditor is key in ensuring that companies full comply with statutory regulations and corporate governance. An auditor will scrutinise the accounting records and financial statements concluding their findings with an impartial report, including any discrepancies or irregularities found.

Financial accounts are the most common method in which the shareholders are able to monitor the performance of the directors and the company. The external auditor provides an independent report to the shareholders on the truth and fairness of the financial statements that are prepared by the board of directors. It is in the power of the audit committee to appoint the external auditor. The reports produced by the external auditor on behalf of UK companies are required to be listed in the public domain – this information is freely available at Companies House.[60] Although under Section 235 of the Companies Act 1985 auditors are appointed by and report to the shareholders of the company, there may be other stakeholders who believe that the independent audit serves their best interests too. Banks and creditors will use the audited financial reports to perform credit checks before offering credit agreements; customers may use the reports to decipher how secure the company is before making a purchase or investing in a project; and employees may use it to check on job security and performance. Owing a duty to those other than the shareholders sees a more stakeholder orientated approach to corporate governance.

3.5 Chapter Conclusion

In summary, the developments in corporate governance and law have seen a move away from shareholder theory and the original ideology that corporate governance: is a system of directing and controlling a company; and that it maintains that a company should be run in the sole interest of the shareholders without regard to other factors. By exploring the reform, it is clear that adjustments have been made to ensure the views of the wider stakeholder are acknowledged by the directors and in turn this has provided for additional accountability and transparency.

The codification and nature of director’s duties in the Companies Act 2006 puts the directors under a statutory duty to promote the success of the company for the benefit of the shareholders, whilst showing consideration to the interests of the other stakeholders. In addition to this, and in combination with increased transparency and accountability in the Corporate Governance Code reform, the idea that a company should be managed in the best interest of the shareholders as an extension of their personal wealth has subsequently been rejected. When making executive board decisions, the board of directors now need to have regard for stakeholders’ interests – this is very much the overarching principle behind the reform.

3.4 Enlightened Shareholder Value Theory

As mentioned earlier under section 172(1)[61], directors are required to ‘have regard’ to a wider range of factors, including: the prosperity of the company; long term consequence; employee interests; customers and suppliers; and impacts on the immediate environment and community. Although directors are required to account for these interests of the wider stakeholder under the act, no additional duty or accountability is owed to the stakeholders in the way in which the directors owe a duty to promote the success of the company for the benefit of its members as a whole i.e. the shareholders. It would be wrong to see the purpose of Section 172 as requiring the directors to balance the shareholder and stakeholder interests alongside each other, as this would be impossible due to the differing interests of each stakeholder group and differing interests within said groups. [62] This view of Section 172 is supported by industry guidance published on the effects of s172.[63]

Despite corporate governance reform pointing towards directors creating a balanced company for all stakeholders, due to the wording of Section 172 it has been interpreted that the approach is that directors are to be ‘enlightened’ by the views of the aforementioned factors rather than to balance the views of all.[64] This has given rise to a slightly alternative version of stakeholder value theory, known as ‘Enlightened Shareholder Value’[65] theory. ESV theory, proposed by Jensen in ‘Value Maximization, Stakeholder Theory and the Corporate Objective Function’[66], ascertains that the promotion of members’ interests (members being the shareholders’) is unlikely to be achieved if business is conducted without regard to its employees, customers, suppliers and other stakeholders. The theory encourages and promotes the directors to run their day-to-day business with foresight of long-term goals and aims to incorporate parts of the shareholder and stakeholder theories by allowing for stakeholder interests to be considered as part of the director’s duties. Under the enlightened shareholder value theory, the idea is that corporate governance is a…

“system comprised of all of the internal mechanisms enabling shareholders to be informed of the proper functioning of their company, controlling it through their AGMs and by the powers they delegate to the Board of Directors, while ensuring corporate strategy in compliance with existing laws in the long-term interest of the firm.”[67]

This enlightened shareholder value definition of corporate governance is encapsulated in the UK Corporate Governance Code 2016, where the purpose of corporate governance, today, is defined as “to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.” From this definition it is ascertained that the fundamental principle imposed on a board of directors is that they are obliged to promote the long-term success of the company as this best benefits the shareholders whilst accounts for the interests of the stakeholders.

[1] Geoffrey Poitras, Handbook Of Research On Stock Market Globalization (Edward Elgar Publishing Limited 2012).

[2] Abbreviated to ‘UK’.

[3] https://en.oxforddictionaries.com/definition/corporate

[4] https://www.vocabulary.com/dictionary/greed

[5] Balot, R. K. 2001. Greed and injustice in classical Athens. Englewood, NJ: Princeton University Press.

[6] Dr Saleem Sheikh, ‘Perspectives on Corporate Governance’ in Sheikh and Rees, Corporate Governance and Corporate Control (Cavendish, 1995), 5

[7] ‘Public Company’ <http://www.investopedia.com/terms/p/publiccompany.asp> accessed 22^nd September 2017

[8] Companies Act 2006, ss 9(1)

[9] Companies Act 2006, s 154

[10] Interchangeable with the abbreviation ‘CG’, herein.

[11] Adolf Berle and Gardiner Means, The Modern Corporation and Private Property (2nd ed, Transaction Publishers, 1991)

[12] Milton Friedman, Capitalism and Freedom (University of Chicago Press 1962)

[13] William Lazonick and Mary O’Sullivan, ‘Maximizing Shareholder Value: A New Ideology for Corporate Governance’ [2017] Vol 29 Economy and Society <http://www.tandfonline.com/doi/abs/10.1080/030851400360541> accessed 23 September 2017

[14] Michael C. Jensen and William H. Meckling, ‘Theory Of The Firm: Managerial Behavior, Agency Costs And Ownership Structure’ [1976] 3 Journal of Financial Economics <http://uclafinance.typepad.com/main/files/jensen_76.pdf> accessed 23 September 2017

[15] Andrew Keay, ‘Enlightened shareholder value, the reform of the duties of company directors and the corporate objective’ in Lloyds Maritime and Commercial Law Quarterly [2006] 335-361, 336

[16] Adam Smith, The Wealth of Nations (1^st edn, W Strahan and T Cadell 1776)

[17] Lee Brodie, ‘Carl Icahn Attempting to Unlock Value in CVR Energy’ CNBC [2012] http://www.cnbc.com/id/46388674> accessed 22^nd September 2017

[18] William W. Bratton, Hedge Funds and Governance Targets, 95 GEO. L.J. 1375, 1401 (2007)

[19] Stephen Bates, ‘How Polly Peck Went From Hero To Villain In The City’ The Guardian (2010) <https://www.theguardian.com/business/2010/aug/26/polly-peck-business-asil-nadir> accessed 22 September 2017

[20] http://www.dailymail.co.uk/news/article-3561762/Disgraced-tycoon-Asil-Nadir-returns-hero-s-welcome-native-Cyprus-release-UK-prison-cheating-investors-millions.html#ixzz4xSINbjH6

[21] Simon Bowers, ‘Files Close On BCCI Banking Scandal’ The Guardian (2012) <https://www.theguardian.com/business/2012/may/17/files-close-bcci-banking-scandal> accessed 22 September 2017.

[22] E. Merrick Dodd, a professor at Harvard Law School

[23] R. Edward Freeman (1984) Strategic Management: A stakeholder approach, Pitman, Boston, 46

[24] Clarkson M.B.E (1995) “A stakeholder framework for analysing and evaluating corporate social performance”, Academy of Management Review, Vol. 28 No.3, 371

[25] Till Talaulicar (2010) “The concept of the balanced company and its implications for corporate governance”, in Society and Business Review Vol.5 No.3 pp 232 – 244 (Emerald Group Publishing)

[26] James Wallace, ‘Value Maximization and Stakeholder Theory: compatible or not?’ (2003) 15 (3) Journal of Applied Corporate Finance 120 at page 121.

[27] Committee on the Financial Aspects of Corporate Governance

[28] Paragraph 2.5 of Sir Adrian Cadbury’s Report on the Financial Aspects of Corporate Governance (1992)

[29] Andrew R. Goddard, Carol Masters, (2000) “Audit committees, Cadbury Code and audit fees: an empirical analysis of UK companies”, Managerial Auditing Journal, Vol. 15 Issue: 7, pp.358-371, https://doi.org/10.1108/02686900010344638

[30]

[31] Paragraph C4 Greenbury Report 1995

[32] Paragraph C8 Greenbury Report 1995

[33]

[34] Paragraph 1.2 Hampel Report

[35] Paragraph 6.13 Hampel Report

[36]

[37]

[38] Turnbull  and Myners reports.

[39]

[40] Paragraph 1.5 Smith Report

[41]

[42] http://ajobe.journals.ac.za/pub/article/view/59/70

[43]

[44] CG Code 2016 Link

[45]

[46] Hampel Report para 1.1

[47] Companies Act 1985

[48] Mallin 2010 pg 33

[49] In this report https://publications.parliament.uk/pa/cm200203/cmselect/cmtrdind/439/439.pdf

[50] S.172 Companies Act 2006

[51] S.172(b) Companies Act 2006

[52] S.172(c) Companies Act 2006

[53] Guidance on Key Clauses to the Company Law Reform Bill (DTI, 2005), para 63

[54] S.172(1) Companies Act 2006

[55] Keay, ‘Section 172(1) of the Companies Act 2006: An Interpretation and Assessment’, Comp. Law 2007, 28(4), 106-110, at page 108.

[56] https://dictionary.cambridge.org/dictionary/english/entrenchment

[57] Milton Friedman, Capitalism And Freedom (40th Anniversary edn, University Of Chicago Press 2002).

[58] S1 2009/1632

[59] S.485(4)(a) Companies Act 2006

[60] Government Department.

[61] Companies Act 2006

[62] Keay, ‘The duty to promote the success of the company’ (n 3) 17.

[63] ICSA International, Guidance on Directors’ General Duties (2007) [3.2] accessed 12 June 2012; GC100, Companies Act 2006 – Directors Duties (2007)

[64]Keay, ‘The duty to promote the success of the company’ (n 3) 11.

[65] Abbreviated to ESV, herein.

[66] JENSEN, Michael. (2001), Value Maximization: Stakeholder Theory and the Corporate Objective Function, Journal of applied corporate finance

[67] https://www.researchgate.net/publication/228238982_Enlightened_Shareholder_Theory_Whose_Interests_Should_Be_Served_by_the_Supporters_of_Corporate_Governance?enrichId=rgreq-6584534d4f0175a9b3935d7c88e2482c-XXX&enrichSource=Y292ZXJQYWdlOzIyODIzODk4MjtBUzoyNDQ2NjYxMjE1ODQ2NDJAMTQzNTM0NDM1NzYwNA%3D%3D&el=1_x_2&_esc=publicationCoverPdf