Interests of stakeholders

Are the Interests of Stakeholders Adequately Protected in the UK or Are Further Reforms Needed?

Abstract

This article seeks to explore the protection measures provided to stakeholders under the UK legal regime and whether or not the level of protection provided is adequate for the protection of stakeholder interests. The three most common systems of setting the objective of a company are discussed initially in order to establish a strong theoretical background for the rest of the paper. In the following section, the importance of stakeholders as a group and the reasons for the legal system to look after their interests is examined. The article then explores the protection provided to stakeholders under the current UK legal regime with a special emphasis on the protection provided via the Companies Act 2006, Insolvency Act 1986, and the Voluntary Codes of Corporate Governance. Possible reforms that could improve the current state of protection for the stakeholder group and provide a much stronger system of corporate governance are then suggested. The article concludes by indicating that the current UK legal protection measures for the interests of stakeholders are weak and emphasizes on the need to reform the current state of law in order to not only protect stakeholder interests, but also to maximize wealth creation for the society as a whole.

Objectives

The main objective of this paper is to find whether the reform or laws are wider enough for the protection of the stakeholder under the UK legal regime, if not, what possible reforms could be suggested for stakeholders protection.

Specific objectives

  • Analyse why stakeholders in the United Kingdom need protection for their interests in the organisation.

  • Based on the analysis, find out what kind of protection measures available to stakeholder for protection of their interest.

  • Suggest possible reforms which can be adopted by the UK legal regime and incorporated into law for the further protection of stakeholder's interest.

Research methodology

The type of research used in this paper is a descriptive research. Through this study and report my objective was to understand and analyse how stakeholder's interest are protected in the UK. What other possible reforms will play a key and vital role in the further protection of the stakeholder's interest. This study attempts to make a systematic description of the situation faced by the stakeholder's facing a highly competitive environment in the UK.

In order to get a whole view of the stakeholder's protection, a mixture of structured and unstructured approach has been adopted resulting in quantitative and qualitative information. There are numerous talks in the mixtures of two methods of research (Brannen J., 1992) (Brewer H., Hunter A., 1988). However, its complementarity is a valuable tool for several studies due to the hard conditions to implement a unique mode to collect the amount of information necessary for this research (and also the duration of the project), and the possible lack of accuracy to put in plain words a single case if all the information used is quantitative. It is considered a mix of both methods, according to the needs exposed by each section of this work.

In the earlier chapters, the qualitative approach was adopted to gather the information about why do the stakeholder's interest needs protection in the UK and what measures are made available to the stakeholder for the protection of their interest by the UK legal regime. This approach was needed to know why some decisions were taken by the management while leaning their interest on the shareholder's and not on the entire stakeholder's. This stage required in-depth information and explanation of complex situations.

I had to dig information and for my report through secondary data available through various journals, reports, white papers, research papers, articles and other sources. A more structured approach was adopted to gather secondary data. This secondary information is gathered by laying special emphasis on Companies Act 2006, Insolvency Act 1986, and the Voluntary Codes of Corporate Governance and several government studies. The chapters in this document are taken from varied secondary sources and data as stated in the references. In the later chapters of this document, I have depicted how the impact of reforms could improve the current state of protection for the stakeholder's. This study considered the different sources used as valid and reliable, supported in the different sources where it was obtained.

Introduction

The debate over the implementation of either a shareholder oriented model of corporate governance or a stakeholder oriented one has been a popular one for a number of years now. In the UK, the established system carries more similarities to that of the US, which principally promotes the interests of shareholders over all other constituencies. This is in contrast to the rest of Europe or Japan where a more stakeholder inclusive approach has been adopted.

However, with the increase in number of recent corporate scandals, beginning from the Enron and WorldCom affairs, the UK has implemented changes into the present shareholder supremacy model and broken the status quo through the work of the Company Law Steering Committee and the subsequent enactment of the Companies Act 2006. The role of NGOs and other environmentalists have pressurised UK Companies to adjust their approach in the direction of corporate governance and has also supported in promoting awareness of developing a stakeholder oriented society. After the dumping of Brent Spar the public boycott against Shell products is a typical example of the kind of protests that is being carried out by affected groups today.

This document commence with giving a brief analysis of the three common systems of Corporate Governance that are used normally in setting the objectives of an organization. By serving as a strong basis for the arguments put forth in this article, this analysis will facilitate in understanding the significance of increasing the protection available for stakeholders in the UK.

The subsequent section will focus on the principal reasons why stakeholders be worthy of protection under the law in the first place. Many critics of the stakeholder oriented system dispute that stakeholders are free to contract with the firm and use their bargaining power to their advantage; therefore, there is no need to provide them with additional legal protection. However, this section will provide an important insight into why this argument is unsound and suggests various reasons why indeed stakeholders need their interests to be protected by the UK legal regime. It will also seek to express the importance of stakeholders to the firm and the merits of additional protection given to them.

The paper will then proceed to identify the current avenues of protection available to the shareholders under the current UK legal system. The focus of the article will be on the Companies Act 2006, Insolvency Act 1986, and the Voluntary Codes of Corporate Governance.

Following the study of the existing level of legal protection available to interests of stakeholders in the UK, this article will attempt to show the weaknesses of this regime and the adverse effects it has on the interests of stakeholders through an illustration of a company faced with the threat of a takeover.

Even though a number of reforms have been recommended in academic literature, the latter part of this document will focus on two in particular, namely the introduction of Self Governance and increasing the role of Institutional Investors in protecting the interests of stakeholders in the UK. Increasing evidence has suggested that mandatory compliance with fixed legal rules or even voluntary compliance with a standardized code of rules has not yielded the desired outcome as far as improving the corporate governance of UK companies is concerned. Therefore, a possible solution is for the government to act in a supervisory capacity while allowing companies to form their own customized set of corporate governance rules. Furthermore, increasing the role of institutional investors in setting the strategic objectives of the company will not only aid the long term development of the organization, but will also compel the management towards giving greater regard to the interests of the company's stakeholders.

Theoretical Background

What are Stakeholders?

There has been a continuing argument over the development of a unanimously acknowledged definition of a stakeholder. Freeman, one of the foremost contributors to the notion of the Stakeholder Theory quotes the Stanford research institute (SRI) as using the word ‘stakeholder' in 1963 to describe “those groups without whose support the organization would cease to exist (Turnbull, 1997).” He himself to some extent uses a varied definition of a stakeholder as being “any group or individual who affects or is affected by the objectives of a company (Freeman, 1984).” The stakeholder theory was later developed and championed by R. Edward Freeman in the 1980s (Freeman, Edward et al, 1983). In our discussion we will rule out the shareholders of a firm from being a part of the stakeholder faction and treat them independently as having diverse interests.

Donaldson and Preston bound their focus and give a narrower definition of a stakeholder as being “identified through the actual or potential harms and benefits that they experience or anticipate experiencing as a result of the actions or inactions of the firm (T Donaldson and L Preston, 1995).” In general, stakeholders are individuals or groups that have some claim on the company. They can be divided into internal claimants and external claimants. Internal claimants are stockholders and employees including executive officers and board members. Whereas external claimants are all others individuals or groups affected by the company's action comprise of customers, suppliers, governments, unions, competitors, local communities and the general public.

However, for realistic purposes, the technicality in defining stakeholders is not the main objective. Rather, understanding the significance of stakeholders in the flourishing functioning of a firm carries primary importance.

Different Approaches Followed By Firms To Set The Objectives Of The Company.

Shareholder Value and Stakeholder Value have remained the competitor objectives of the firm for a number of years. Whilst the Anglo American countries favour the first, the Asian and European countries rely on the second as the primary purpose of the firm. Due to the recent business scandals, a new system known as the Enlightened Shareholder Value has now taking place to appear in the UK.

Shareholder Value Approach

The long-established sight of the firm has mainly been a shareholder oriented one. In addition acts as a vital notion in the creation of corporate governance mechanisms in the Anglo American community. In this conception, the firm is operated for the gain of the shareholders who are owed a fiduciary duty by the board of directors (BOD) acting as their representatives in making the strategies to be adopted by the company. The BOD is nominated by the shareholders to act on their behalf and to make sure that the working of the firm is aligned with their interests. The shareholders are viewed as the owners of the firm since they maintain to be the remaining risk bearers of the firm's returns and strategy arrangements are aligned with their interests.

The shareholder value approach is supported through the nexus of the contracts theory, which in disparity to the organic theory, argues that all stakeholders are sheltered by means of contract with the firm and need no extra protection.

One of the key difficulties in the shareholder value approach has been to facilitate the agency problem. As the ownership arrangement in the UK is widely dispersed, shareholders who assert to be the owners of the company cannot energetically take part in monitoring the company management (A Gamble and G Kelly, 2001). As their comparative stake in the company, is too low for them to stand the expenses involved in pursuing such a task. Therefore, as said earlier, they nominate a BOD which on their behalf monitors the management and guides the strategy formation of the firm. Though, the board is generally leaning to guard its own interests and wishes to stay away from developing any roughness with the management of the company. Because it is the management, that determines their income and fringe remuneration. Consequently, this results in their shareholders being worse off since the body they nominated to signify their interests is not performing efficiently and resourcefully.

To tackle this dilemma, UK company law has used a range of techniques to watch management and board doings namely director remuneration through issuance of share option, the presence of a minimum number of non executive directors on the board, and the development of accounting metrics, i.e. ways of measuring corporate performance by reference to shareholder returns (Deakin, 2005).

Along with the many benefits of the shareholder value approach that have been stated, two that hold major significance are the efficiency argument and creation of an effective accountability mechanism. Under the efficiency argument, it is said that this approach creates the finest situation for wealth maximization and provides a motivation for businesses to manufacture the products and services demanded by the consumers. Requiring the management to deal with the social consequences of running the business will result in inefficiencies and the downfall of the enterprise (Salacuse, 2004).

As far as the formation of an effectual accountability structure is concerned, the solitary job of the directors' is profit maximisation for the shareholders. Thus, they are responsible to the shareholders for the performance of the firm (Vinten, 2001). This is not the case under the stakeholder value approach where the directors are supposed to look after the interests of a number of different constituencies. Consequently result in being responsible to none. As the shareholders are the remaining risk bearers, they have the utmost reason to keep an eye on the management.

Critics of this theory dispute that such an approach leads the administration in the direction of a short term profit-seeking approach. That not only leaves the other stakeholders lacking confidence, but also is not in the long term interests of the company. Furthermore, critics also dispute that an only focus on the interests of shareholders acts as an obstacle in budding a lifelong and mutually favourable bond with stakeholders.

Stakeholder Value Approach

The stakeholder vision of the firm is a budding approach that contradicts the claims of the shareholder value approach. Proponents of the theory dispute that the shareholder value approach has turn out to be an out of date conception. The aims and objectives of the firm are diverse in today's modern world where human capital carries much more importance than the value of physical assets. (S Letza, X Sun and J Kirkbride 2004). The main stakeholders under this theory are employees, suppliers, creditors, customers, and the environment (Kooskora, 2008). The theory contends that the hard work of all stakeholders emotionally involved to a company's performance should be treated uniformly. No other faction ought to be given supremacy in excess of the other. Thereupon, the theory argues that shareholders are also one of the constituencies in the broader stakeholder faction and should be treated as such instead of being given the sole power to control the company. Advocates of this theory also consider that shareholders are not the only remaining risk bearers, besides them it is also the other stakeholders that share a major segment of this risk. While the shareholders bear the possible loss of their investments, workforce bear changes in the terms and conditions of their contract and possibly end up losing their jobs. Customers face price hikes and reduced product quality while, the local community may suffer from adverse environmental impact resulting from company operations (Kiarie, 2006). Hence, shareholders should not be given the exclusive right in the creation of company policies and objectives. Rather a more stakeholder oriented approach should be followed to deal with these concerns.

In order to flourish, companies are continuously looking for dedicated and skilful workforce, responsible suppliers, good relations with the local community and government and brand loyalty from consumers. The stakeholder value approach provides the firm with the opportunity to achieve these objectives and encourages stakeholders to invest in long term relationship building measures with the company (Dean, 2001).

Moreover, stakeholder value encourages a long term approach to running a company (Vinten, 2001). Whereas shareholder value lays enormous stress on share price and short term profitability, stakeholder value lays emphasis on constructing a sustainable organization having long lasting encouraging bond with a range of stakeholder constituencies.

However, critics of this theory point out that the theory may probably lead to lacking managerial direction and delays in decision making. With increased stakeholder groups whose interests have to be looked after, managers might encounter themselves in a state of dilemma. Thus, a plain accountability mechanism will also require to be developed. Moreover, in setting the companies' objectives representations from each stakeholder group will have to be such that it does not damage the company in terms of delayed decision making. As sense of timing is a vital component in running a successful venture.

Enlightened shareholder value approach

After the corporate scandals which took place during the last decade, that of Enron and WorldCom. Legislators in different countries attempted to develop ways that could wipe out the likelihood of such incidents recurring in the future. Whilst the US brought forward the Sarbanes Oxley legislation, the UK - through the recommendation of the Company Law Review Steering Group - steered slightly away from the absolute shareholder value approach towards a view called the Enlightened Shareholder Value (ESV) approach. The views of the Steering Group were incorporated into the Company Law Reform Bill 2006, discussed in Parliament, and subsequently approved. (Berr.gov.uk; The Company Law Review Steering Group, DTI, ‘Modern Company Law for a Competitive Economy: Developing the Framework', 2000).

The ESV approach maintains profit maximization as the primary function of an organization, but unlike the shareholder primacy argument it does not terminate there. The ESV approach continues to stress on the significance of decision making that results in long term value creation of the firm by giving regard to the interests of the organisation's stakeholders and through the development of long term relationships of trust with them (Deakin, 2005).

After the Bill was passed, it resulted in the subsequent changes in the Companies Act 2006 through the codification directors duties which were previously un-codified. The most important change made was through the introduction of Section 172: Duty to promote the success of the company. This section of the Act imposes a duty that requires the director to act in the way he considers, in good faith, would be most likely to promote the success of the company and this duty is still owned to the members as a whole. While exercising this duty the director is required to, in so far as he considers reasonably practical to do so, give regards to the interests of the company's employees, the relationship with the suppliers, customer, the environment and the local community. Although this list is not exhaustive, it projects a fair description of what the ESV approach stands for and maybe a step in the right direction. Since it is the first time that the law has explicitly required the directors of the company to give regards to the interests of its stakeholders. More in depth explanations of the merits and demerits of section 172 will follow when considering the protection provided to stakeholders under UK law currently.

Why Do Stakeholders Need Protection?

Despite the varying perspectives of the various different theories of the firm, they all have the same opinion on at least one thing: a firm cannot exist without stakeholders (M Greenwood, 2001). Although shareholders are an extremely vital constituent in effectively running an organization in their capability as the primary finance providers, there are numerous organizations that exist without them. Examples of such organizations are law firms which are owned by their employees.

The stakeholder approach and even the enlightened shareholder value approach which is currently prevalent in the UK, dictates the significance of other stakeholders such as employees and customers to the company. This section also mentions the circumstances where shareholders were given preference over the other stakeholders by the management. Though shareholders, employees, suppliers and creditors etc. all are stakeholders, they should be treated fairly by the management.

Even though stakeholders form an essential part of a firm, there is a constant debate on whether they need additional protection under UK law. Rather than merely the protection received by means of contracting with the firm. Academic literature has formed various reasons why stakeholders of the firm perhaps require such additional protection. Some of the essential reasons are discussed below.

Contractual Protection Does Not Fully Protect Stakeholders

Residual claimants' argument: The main reason why shareholders have given the power over the operations of a company is because they assert to be the residual claimants over the company's assets as their claims are not absolutely protected via contractual mechanisms. The return on a company's stock is not fixed and if a company makes losses the shareholders do not receive a return on their investment via dividends while the remaining of the stakeholders are covered by their individual contracts. Moreover, in the case of a winding up process of the company, the shareholders are the last to receive their share of the company's assets after all the fixed contractual claims of the company are settled.

However, opinions have emerged that do not acknowledge this view totally. At the same time it is generally agreed that the control of the company should be placed with the residual claimants of its assets, there has been considerable debate on which the actual residual claimants are (Blair, 1995). While shareholders assert that they remain the sole residual claimants of a company's assets, on the other hand employees hold their own point of view. The employees of a firm think that in cases where they acquire firm specific skills, their value in the market is less than their value in the firm. They hold the opinion that they have made specific investments and contributions towards the success of the firm. They believe that they should have a right to be a part in its decision making process as their futures are now emotionally involved with the performance of the company. Examples of such employee participations are found in Germany where employee representation is done through Supervisory Boards which play an important role in the decision making capacity of the board of directors (Schneider, 1992).

Whilst employees uphold their view as being part of the residual claimants of the firm, certain suppliers argue the same (Williamson, 1991). In many instances, suppliers while contracting with the firm set up services and buy equipment specific to the firm they are supplying to. In doing so, they make a long term commitment with the firm which cannot be covered merely through contract. Therefore, by making such firm specific investments, they as well think to form part of the residual claimant structure of the firm. And they want to have authority over the formation of the firm's strategic policies and objectives.

High cost of contracting: The idea of contracting is for the service providers to look for a little, if not whole, protection for the services they provide. Whilst contracting remains a positive mode to look for protection, it on number of times fails to offer full protection to the stakeholder of a company. Firstly, contracting lead to many costs that cannot be borne by all stakeholders. It is hard for the comparatively smaller stakeholders to involve in detailed contracting. As the high costs of preparing an in depth contract cannot be borne by them. Moreover, such stakeholders do not have sufficient bargaining power to put in order such a thorough contract that may possibly limit managerial power. Indulging in detailed contracting would perhaps not even be advisable for stakeholders which do possess this high bargaining power since this will obstruct the management's ability to function effectively.

Protection Against Dysfunctional Managerial Decisions

The task of a company's management is to prop up the success of the company by providing it with strategic direction and aiming towards its long term growth and prosperity. In return the company compensates the management through cash salaries, bonuses and stock options. This transaction would make it seem that the management should work for the interest of the company as a separate legal entity.

However, since shareholders are the controllers of the company through their voting rights and in many cases take an active part in determining the earnings of the managers, the management is susceptible to making dysfunctional decisions that favour the shareholders while damaging the other stakeholders and the company as a whole (J Day & P Taylor, 1998). Amongst many, these decisions include high dividend payments, claim dilution, asset substitution, and risk shifting. Therefore, in order to secure the interests of other stakeholders in relation with the shareholders there is need for additional protections for all stakeholders.

When a company is in financial agony or is heading towards it, the managers may have a propensity to side with the shareholders by issuing high dividends which will trim down the finances available to the remaining of the stakeholders. This action will not only be to the disadvantage of the stakeholders, but will also adversely affect the company and damage its reputation since it will diminish the likelihood of its revival. However, since the shareholders hold close ties with the management, they receive privileged treatment over all other stakeholders.

Risk shifting is another instance of management siding with the shareholders. When a company is close to insolvency, company law requires the management to shift its focus to owing fiduciary duties to creditors instead of owing these duties to shareholders. In such distressed times, only the shareholders will benefit from further investments even though the risk is borne by the creditors. In such cases, the management might be unduly pressurised by the shareholders into indulging in enormously high risk and high return yielding projects. Since the accomplishment of such projects will make sure that the shareholders will gain along with the creditors. However, shareholders will have nothing to lose if the project is unsuccessful and the actual burden will drop on the creditors. As the company will now not even be able to meet its fixed obligations owed to them.

Customers are also stakeholders to a company and they rely on adequate pricing practices and fair practices by the directors of the company. Since the privatisation of previously government run industries customers are in need of protection (S Ogsen and R Watson 1999) and directors who are inept at their job may hinder customers as well as other stakeholders, such as the government who want fair practices and competently run companies.

Monitoring Costs

Even though the stakeholders of the company are free to contract with the firm and protect their interests, the monitoring costs incurred in ensuring that the contract is not breached are an additional burden on the stakeholders (S Longhofer & S Peters, 2004). While a number of stakeholders may be capable of supporting such costs, many will not as they will not acquire the adequate resources to expend on the monitoring purpose.

Moreover, it is also vital to realize that the risk attached to many business functions changes once the stakeholder has contracted with the firm (T Telfer, ‘Risk and Insolvent Trading' (1998) Rickett and Grantham). Due to the incapability of numerous stakeholders to monitor firm's activities, they are not in a situation to find out the change in the riskiness of their investment and consequently are in a much more fragile circumstance than they perceive it to be.

Therefore, the law needs to supply a framework that will necessitate the management to meet up their obligations to these stakeholders and protect their interests in the company.

How are Stakeholders Currently Protected Under UK Law?

Although there are number of legislations protecting the interests of various stakeholder constituencies like the Employment Act 2002, Environment Act 1995 and various others, the focus of this paper will be on the major reforms brought under the Companies Act 2006, Insolvency Act 1986, and various voluntary codes of compliance introduced during the last two decades beginning form the Cadbury Code in 1992.

Protection for Stakeholders Under the Companies Act 2006

The notion of the stakeholder value approach has been growing for a number of years and, along the way, increasingly raising concerns over the acceptance of the shareholder primacy model. In the Companies' Act 2006, (hereinafter called as Act) the debate of increased stakeholder protection finally made considerable progress through the codification of directors' duties towards protection of the stakeholders of the company. As far as stakeholder protection is concerned, amongst the various provisions of the Act that codifies the duties of directors towards the company, section 172 (Companies Act 2006 Handbook, Twenty first Edition, Butterworths 2007) remains the most significant one.

This section requiring the directors to “Promote the success of the company” is not only a codification of the previous law, but is also the introduction of a new one (Out-Law.com, 2007). For the first time, the duty has been imposed upon the directors of a company to promote the success of the company while giving regard explicitly to the interests of its stakeholders. In the past, the language used in the Act required the director to act “bonafide in the best interest of the company”. In real meaning, this duty is amended in the updated Act of 2006 through the obligation of the directors to act in good faith and to promote the success of the company (Berr.gov.uk; D Chivers, 2007). However, what has altered is that the Act now not only prescribes the duty owed by the directors of a company, but also the way they are supposed to discharge this duty (Berr.gov.uk; D Chivers, 2007).

Prior to the Act was passed, there were rising concerns of whether or not setting out a detailed list of stakeholders, before making any decisions the interests of which the directors would have to give regard to, would convince a formal box ticking approach. This could have led to ever-increasing administrative burden for the company which lack in bringing any considerable change in the behaviour of directors (Berr.gov.uk; D Chivers, 2007). However, these concerns were shrugged away by the government suggesting that the section requires directors to ‘think about' the interest of stakeholders so that their stake in the company may be protected (Berr.gov.uk; Ministerial Statement, 2007).

Even though section 172 requires the directors to give regard to the interests of stakeholders, it does not mean that they should compromise the interests of the company in order to protect the interests of any of the stakeholders. All it does is formalise the duty imposed by law on the directors to give due regard to the interests of the specified stakeholders and at the same time making decisions in the best interest of the company which is the essence of the Enlightened shareholder value approach.

Another addition into the law that has come through the incorporation of Section 172 has been that of preparing a Business Review at the end of the financial year. With the exception of companies that are part of the small businesses regime, directors of a company are now by law required to produce a Business Review the purpose of which is to provide information to the members of the company in order to help them assess how the directors have performed their duty under section 172 of the Act.

In the business review the directors are required to reveal a true and fair sight of the company's business along with a description of the principle risks and uncertainties that are facing the company (http://www.berr.gov.uk/bbf/financial-reporting/business-reporting/page21339.html). Moreover, the directors are also required to prepare an analysis of the company's performance using financial and other key performance indicators.

The business review for quoted companies carry extra requirements including trends expected to affect the future expansion, information about environmental matters, the company's employees etc. However, revealing this information may be avoided if the directors consider that it will be gravely detrimental to the person contracted with or adversely affect the interest of the general public.

Even though the Business Review may be the move in the right path as far as the stakeholders are concerned, it still does not bring the same level of protection for the stakeholder and disclosure of information concerning the actions of the company that were introduced through the Operating and Financial Review(OFR). However, the OFR was repealed soon after its introduction and hence not incorporated into the Companies Act 2006. Therefore, it remains to be seen whether the Review will be able to follow through with its desired objective of providing additional protection for stakeholders.

The Act also provides the Authority (which currently is the FSA in the UK), the discretion to form Corporate Governance rules as they deem appropriate through Section 1269 of the Companies Act 2006. This section inserts a new section 890 into the FSMA 2000 which gives the Authority a power to make rules implementing or enabling the implementation of or dealing with the matters relating to the community obligations on corporate governance of issuers on a regulated market. This rule making power will allow the authority to create corporate governance rules in order to cover issuers for whom the UK is the home member state and whose securities are traded on a regulated market in the UK. In essence this section provides the Authority the power to determine the relationship between the issuer and its organs with regard to corporate governance issues. Even though this section provides the Authority with a broad discretion on protecting the interests of stakeholders, the elements of the provision seem to be unclear and it is however to be observed if they aid the stakeholders of an issuer which listed on a regulated market in providing useful contribution for the corporate governance issues of a firm.

Protection for Stakeholders through the Compliance of the Voluntary Codes

Starting from the Cadbury Report being published in 1992 till the issuance of the Higgs review in 2003, the corporate governance field in the UK has witnessed the development of number of Codes aimed at making better the governance structure of an organization. These reports have focused on issues such as the role of Non Executive Directors, Audit Committees, Directors' Remuneration Committees, and Internal Controls etc and have been implemented by the majority of large public and private organizations in the UK. Most importantly, the London Stock Exchange has mandated the compliance to the Combined Code on Corporate Governance to be implemented by all its quoted companies.

Even though compliance with these various codes of corporate governance will most likely to improve the performance of the company at large, the codes fail to necessitate the management to explicitly look after the interests of stakeholders (K Bondy, D Matten and J Moon 2004). These codes seem to provide special emphasis on the role of shareholders in the governance of organizations in the UK which is a rather obvious portrayal of the strong roots of the shareholder primacy model that are still existent today.

Protection for Creditors and a Stakeholder Constituency

Amongst the Stakeholder group, the Creditors being one of the most significant stakeholders to whom the special legal attention have been provided not only under the Companies Act, but also through the incorporation of the Insolvency Act 1986.

Though, this rule in practice only provides with a false sense of security to the company's creditors. Firstly, the minimum amount of capital to be raised is independent of the riskiness of the business which is pretty complicated to understand. Secondly, even if the minimum capital has been raised and is not authorised to be returned to the members of the company, it still does not prohibit the legal capital to be lost via trading losses.

One argument that is continuously used to support this law is that the rationale of the minimum share capital is mainly to protect the interests of tort victims who are not able to contract themselves with the company. This argument is a sensible one, but then on the other hand for private companies the non existence of the minimum share capital rule seems confusing since a private company could have as many tort victims as a public enterprise.

Furthermore, the protection is also extended to the creditor through Section 646 of the Companies Act relating to reduction of capital rules by the court. Since the legal capital of a company is raised to protect the interests of its creditors, this section provides them with the right to object a reduction of that capital and appeal to the court. The court may make an order confirming the reduction of capital on such terms and conditions as it thinks fit. However, this too is a fragile type of protection available for the creditors since the company is usually able to satisfy the courts that the claims of the creditors will be met by the company (Davies, Principles of Modern Company Law, 2003).

Moving away from the protection available to the creditors via the Companies Act 2006, they are also additional security provided by the Insolvency Act 1986. Whilst the company is in a solvent state, the duties owed by the directors are to the shareholders of the company. However, once the company reaches a state where it begins to face difficulty in meeting its debt obligations, the law requires the directors to switch duties and primarily look after the interests of the creditors of the company. It exposes the directors (and shadow directors) of a company to personal liability who, at the point that they realize or ought to have realized that the company had no reasonable prospects of meeting its debt obligations, fail to take all the reasonable steps that they are expected to take in order to protect the interests of the creditors (Davies, Directors Creditor-Regarding Duties in Respect of Trading Decisions Taken in the Vicinity of Insolvency, 2006).

The enforcement of this duty is done by sections 213 and 214 of the Insolvency Act 1986 whereby any directors that indulge in wrongful or fraudulent trading will be held accountable by law. The purpose of these actions is to stop directors from indulging willingly or unwillingly in activities that they are aware will harm interests of the creditors of the company and reduce the value of their investment.

Takeovers: Weak Rights of Stakeholders and Increased Exposure to Risk

A takeover is a circumstance where a company, commonly identified as the acquirer or bidder purchases another company known as the target. In the UK, this purchase usually concerns a public company the shares of which are listed on the stock market (Jenson, 1986). There are commonly three kinds of takeovers: a friendly takeover, a hostile takeover, and a reverse takeover.

A friendly takeover is where before a bidder makes an offer for another company, it usually first informs the board of directors' of that company. If the board feels that accepting the offer will better serves shareholders than rejecting it, it recommends the offer be accepted by the shareholders (www.investopedia.com). A hostile takeover allows a suitor to bypass a target company's management unwilling to agree to a merger or takeover. A takeover is considered "hostile" if the target company's board rejects the offer, but the bidder continues to pursue it, or the bidder makes the offer without informing the target company's board beforehand (www.investopedia.com). A reverse takeover is a type of takeover where a private company acquires a public company. This is usually done at the instigation of the larger, private company, the purpose being for the private company to effectively float itself while avoiding some of the expense and time involved in a conventional IPO (www.investopedia.com).

There are a small number of core reasons why takeovers take place. The first is the profitability argument where a takeover takes place when the bidder feels that the company is reasonably priced and will yield good profitability in the future (E Berkovitch & M Narayanan, 1993). However, the second cause carries more strategic motives instead than those of profitability. These motives include increased economies of scale through the purchase of the target, entry into new markets without taking on the burden of opening a new division, to eliminate competition, and remove redundancy if both the bidder and target have similar functions (B Bennett, 2005, University of Sydney).

Takeovers can probably have enormously damaging effects on the interests of the stakeholders of the company. Firstly in order to improve the efficiency of the firm takeovers by and large result in job cuts and this noticeably exceedingly harmful to the interest of employees.

Secondly, in order to have a superior grip on the market takeovers are often carried out so as to eradicate competition from the market in which they are operating, acquirers commonly buy out their targets with the cost of reduced choices and higher prices endured by consumers.

Thirdly, takeovers hurt the stakeholder body as a whole since the danger of takeovers promotes a short term approach on behalf of the managers. Since takeovers usually being result in replacing the existing management team by a new one, the current management indulges in behaviour that would protect the company from being taken over by the bidder. Two of such actions include increased issuance of dividends by which the current shareholders would be pleased, as well as, increasing the short term profitability of the firm and subsequently increasing the stock price making it further hard for the bidder to take over the company.

It is a broadly measured belief that the likelihood of a corporate takeover acts as a corrective mechanism for the current management to perform effectively or be taken over and substituted by a better management team. It is also generally suggested that the new management results in an improvement in the company's efficiency and performance (V Kennedy & R Limmack, 1996). However, empirical research points out that the profitability of firms taken over is not any better than other quoted companies (J Franks & C Mayer, 1997). This proposes that takeovers are not a mechanism for correcting management failure. In the past, it had been considered that following a merger the performance of a company improves, but this has also now been disproved (The impact of acquisitions on company performance: Evidence from a large panel of UK firms", A Dickerson, H Gibson and E Tsakalotos, Canterbury: University of Kent 1995). This declining performance will ultimately have further long run harmful effects such as the decrease of job security for employees.

Furthermore, it is also believed that the threat of takeover also causes financial difficulties and reduces the resources of the firm. Usually, those stakeholders which could potentially be harmed by a takeover choose to under-invest leading to a shortage of resources for the company. On the other hand, when a takeover is to result in gains for certain stakeholders groups, the takeover bid is rejected since the takeover is not benefiting the shareholders. Thus, stakeholders have the most to lose in such a situation due to their lack of influence over the decision making system in such a situation (Chemla, 2005).

Perhaps stakeholders need to be provided with greater power in a takeover situation in order to reduce the chances of wealth transfer from stakeholders to other constituencies. Offering stakeholders ownership rights, such as the ESOPs in the US, is another way of empowering stakeholders to voice their rights, but it does not provide the ideal solution as it does not guarantee that they will be able to protect themselves against wealth transfers (Chemla, 2005).

Possible Reforms

It is somewhat a straightforward job to point out the defect in a system, but a much more difficult task to put forward a solution to those flaws. Now that the shortcomings of the existing legal regime towards adequate stakeholder protection have already been discussed, it is important to recommend solutions that will effectively address the concerns stated. Out of the many possible solutions that have been put forth in academic literature, In my opinion two of them to be perhaps the best alternatives to the current approach: The introduction of Self Governance and increasing the role of Institutional Shareholders in protecting the interests of Stakeholders in the UK.

Self Governance

One of the essential problems within the corporate governance arena seems to be the nonexistence of the definition of corporate governance itself. One way of defining “good corporate governance” is to base it on the ability of companies to maximize the extent to which they can function on a socially acceptable self-governing basis so as to minimize the need for the government or any regulators to get involved. By implementing such a decision, the empirical test of good corporate governance then becomes how the power used to govern the company is shared amongst the management, shareholders, and stakeholder constituencies and how well their interests are protected using simple laws and regulations rather than costly and complicated ones (SSRN.com; Turnbull S. , 2007).

The mere fact that a growing amount of resources is being consumed by the formation and implementation of laws and codes along with increased regulation expenses is a clear indicator of the failure of current policies (SSRN.com; Turnbull S. , 2007). There exists a distinct need to redefine the direction of the current corporate governance policies to ensure fulfilment of their objectives.

Generally, corporate governance is described not in outcomes that can be measured, but in unquantifiable terms of principles, practices and processes. Thus, there exists no benchmark for regulators or companies alike to strive for when developing or executing their corporate governance strategies.

Likewise, corporate governance failure is being promoted by the absent knowledge of the natural science of governance (SSRN.com; Turnbull S. , The Science of Corporate Governance, 2001) that was developed only a few decades ago. Perhaps the implementation of a bottom up approach is to be called for, allowing investors and stakeholders of companies to become co-regulators and play an active role in forming the corporate governance strategies of the firm. Trustees or government regulators cannot possibly control or even be aware of all the factors that can go wrong. Without stakeholders being empowered with the required resources to protect themselves, neither the government nor the regulators will be able to provide them the due protection that they deserve (SSRN.com; Turnbull S., 2001).

The bottom up regulation system does not necessarily require all the stakeholders to participate actively. A few larger stakeholders can take up the task of participating in corporate governance policy making, resulting in protecting of interests of all the stakeholders (SSRN.com; Turnbull S. , 2007).

Additionally, the formation of such stakeholder advisory forums (SAFs) would clearly be in the interest of both the regulators and directors alike. The SAFs would be able to inform and educate the stakeholders while protecting their interests and also provide feedback from the market to the management in order to improve the operations of the company. Similarly, the SAF's would take over the monitoring role that is currently carried out by the regulators. This would result in substantial cost saving for the companies while also reducing the complication of increased compliance with regulation (SSRN.com; Turnbull S. , 2007).

Nonetheless, the SAFs would have to be adequate authority to independently monitor the governance of the firm in order to remain accountable to their individual constituencies. For example, they will have to be given the right to elect a separate auditor who will independently judge the performance of the company and report back to the SAFs. This remains a big flaw with the current regime since the auditors are remunerated by those whose accounts and operations are being audited (SSRN.com; Turnbull S. , 2007).

Yet another important aspect of the current regime is the role of independent Non Executive Directors (NEDs). These directors are not part of the company's management and have the task of monitoring and assessing the performance of not only the executives but also the board of directors. However, various experiments have proven to a material extent that NEDs cannot be relied upon to provide an independent view since their pays and privileges are set by the same people who they monitor (SSRN.com; Turnbull S. , 2007).

Furthermore, there is a clear deficiency of a systematic process by which the NEDs can carry out their activities using independent sources of information. It is in the best interests of both the shareholders as well as the stakeholders of the company to ensure that such a system is developed, perhaps through providing the NEDs with a SWOT analysis conducted independently of both the management and the business. The most informed and self interested source for conducting such an exercise, as recommended by Micheal Porter would be the employees, suppliers, customers, and the host community within which the firm operates. He suggests involvement of these stakeholders through advisory boards rather than a main board in order to avoid the conflict of interests that are inherent in any stakeholder involvement process. To gain valuable input from these sources, company law must provide each stakeholder constituency the power to nominate and elect its own advisory council which would provide loyal opposition to the views of the management and subsequently provide the NEDs with a different perspective on the performance of the firm (Camac.gov.au; Turnbull S., Submission to PJCCFS inquiry into corporate social responsibility', 2005).

There has also been extensive debate in recent times regarding the need for change in the duties owed by directors with regard to the company and corporate social responsibility. According to Turnbull (2005), no such change is required at present. The directors already have a duty to the “company as a whole” under section 172 of the Companies Act 2006. This automatically means that the directors have a duty to any “strategic stakeholder” on whom the company may rely in order to conduct its day to day operations.

Under the law, there is no duty on the directors to maximize shareholder wealth. The directors are required to work in the best interest of the company as a whole and can make distributions to non shareholders, as in the case of charitable organizations. Thus, there is no legal conflict regarding this issue. The reason why directors indulge in maximizing shareholder value is because of their right to vote as well as their ability to withdraw their funds from the company. Therefore, what is actually required is the setting up of a formal channel through which stakeholders can voice their opinions to the management.

There may also be situations where the strategic stakeholders do not comprise of enough persons to influence the directors in making corrective actions. Only for such a situation should the government perhaps intervene and appoint nominees of stakeholders to influence the directors' decisions.

Another possible correction in the current law relates to the disclosures required by the directors. Due to the excessive disclosure requirements, the directors are made to disclose information that is not contentious and only serves as a contingency for the possibility of something going wrong. This results in very little benefits for the firm and incurs a cost burden on it. Possibly, if representatives of shareholders and stakeholders alike were given the responsibility for certain disclosures to their relevant constituencies, the company would incur significantly less cost in the form of disclosures and also only disclose contentious issues to the public.

One of the primary reasons why company law and government regulations have grown so large and complex is because they have failed to keep themselves at pace with the requirements of the various stakeholders. Instead of maintaining a solicitous role with the companies, they should perhaps have promoted a self regulating one similar to the role carried out by DNA that contains instructions for making all living things self regulating in complex unpredictable environments on a competitive basis (A. Gore, 1991). This would not only reduce costs, but also minimize the size and complexity of laws and regulation (SSRN.com; Turnbull S. , The Science of Corporate Governance, 2001).

Increasing the Role of Institutional Shareholders

During recent times the body of institutional shareholders has evolved in the UK and is now playing a prominent role in setting the strategic direction of the company while paying special emphasis to the interests of stakeholders. Some institutional shareholders are now starting to use their powers to monitor the company's policies. This is not just to protect the stakeholders but more importantly because such policies would hurt the shareholders in the long run (J Armour, S Deakin & S Konzelmann, 2003). Until 1999, around 70% of the UK public equity market was owned by institutional shareholders (www.dti.gov.uk). Not only did this concentrated shareholding provide the institutions with greater control over the companies, but it also aided in removing the free rider problem and institutions could freely exert pressure on the management regarding policy formation (G Stapledon, 1996).

It is also argued that with the evolution of this concentrated ownership structure (SSRN.com; Demsetz & B Villalonga, ‘Ownership Structure and Corporate Performance, 2001), a new category of “Universal Owner” has also emerged, and who is more deeply involved in the running affairs of companies (J Hawley & A Williamson, 2000 & 2003). This is because institutional investors tends to have well diversified portfolios across the listed companies and with the growth in the listed companies, following the privatization of the state owned enterprises, a greater interest for institutional investors across the economy has arisen. Consequently, these shareholders do not benefit from short term stock boosts; rather they look to develop a solid foundation for the company in order to achieve long term growth and profitability (www.dti.gov.uk).

However, there exist certain drawbacks as well of shareholder activism through institutional shareholders. Firstly, due to the increase in international investment, with both UK companies investing in international markets as well as international companies investing in the UK, the funds of UK institutional shareholders are not necessarily aligned with the fate of the UK markets. Therefore, UK institutional shareholders might not necessarily invest in the long term growth of local companies since the majority of their investments could be made abroad. Secondly, it is not necessary that long term policies which are in the best interest of the company are aligned with protection of stakeholder interests. Such instances have been demonstrated through various case studies where for example reduced investment in human capital has been needed to enhance the value of the company in the long run (S Deakin, R Hobbs et al, 2002). Thirdly, accounting standards for environment and social issues have not yet been developed in sufficient detail making it extremely arduous to record the performance of the company regarding such issues.

Keeping these possible drawbacks in consideration, one possible way forward could be to educate the market on how to give regard to stakeholder oriented issues. Conceivably, this could be done via additional disclosure requirements by limited companies relating to stakeholder related issues similar to those that have been proposed in the OFR, recommended by the Company Law Review (Berr.gov.uk; The Company Law Review Steering Group, DTI, ‘Modern Company Law for a Competitive Economy: Developing the Framework', 2000).

Institutional shareholders have typically sought to book profits by selling their shares in a company rather than voicing their concerns regarding its performance. However, due to the increased global emphasis on CSR and SRI along with increased prudential investment requirement, institutional shareholders have started to be actively involved in the management of companies they invest in (J Dean, 2001). Such an attitude has been reinforced by the Myners Reporti.e. encouraging institutional investors to actively indulge in the management of the companies they have invested in to ensure improved corporate governance. Thus, institutional investors are getting involved in voicing their concerns to the management, exercising the voting rights on their shares, as well as attaching conditions on their future investments. They have also collaborated with stakeholder groups in raising concerns regarding the sustainability of the corporation along with pursuing it to actively indulge in community affairs (Mclaren, 2004).

There are various SRI tools that are used by institutional shareholders while making decisions regarding their investments. Two of these tools include the screening process and shareholder activism. Through the screening process institutions can choose to invest in companies that adhere to the required levels of social, ethical, and environmental standard. The second important tool is shareholder activism through which management is persuaded to pursue strategies that go beyond the profit maximization objective and benefit the society as a whole, rather than just the company (J Dean, 2001).

However, it is important to note that even though the concepts of CSR and SRI reach out to tackle stakeholder concerns, they are primarily adopted to increase long term shareholder value. Stakeholder benefits are a mere coincidental benefit. It is quite probable that once these activities cease adding value to long term shareholder investments, they will be discontinued, leaving the stakeholders unsecured again (J Dean, 2001). Furthermore, while gauging the benefits of stakeholder value, it is important to focus more on non-monetary gains rather than monetary ones. Factors like employee loyalty, reliable suppliers and environmental sustainability might not yield direct monetary gains, but go a considerable way in increasing the total wealth of the firm (J Dean, 2001).

Conclusion

Through the course of this paper, a sturdy attempt has been made to highlight the necessity of improving legal protection for stakeholder's interests and to recognize the importance of stakeholders to the success of an enterprise. While it can be unquestionably concluded that the stakeholders are a vital component in the thriving operations of a firm. The channels existing for the protection of stakeholders interests under UK law remain weak and ineffectual; hence leaving the stakeholders lacking confidence and uncertain on the way to creating a long term and significant connection with the company. The roots of the shareholder primacy model seem to stay firmly in place restricting successful reforms in favour of increased stakeholder protection with the repealing of the OFR remaining as a clear example.

Despite the fact that suspicions have been raised over the harmful effects of a stakeholder oriented approach, organizations such as The Body Shop have proved otherwise. Through the sensible usage of social and environmental audits, The Body Shop has been able to recognize how to protect the interests of its stakeholders while also remaining a thriving venture and remains an example of the sustainability of the stakeholder corporation.

Whilst along with the complex laws that the companies are required to adhere to, the Voluntary Codes of Corporate Governance have remained ineffective, perhaps as far as effective Corporate Governance is concerned a change in the direction is required. This shows us the way towards one of the possible reforms suggested in this paper, to be precise the introduction of self governance. With its implementation, firms will be authorised to spread out their own governance structure within a broader framework set by the supervisory body i.e. the government. This will allow organization to build up a corporate governance framework that is appropriate to their individual needs while dropping the unnecessary legal and compliance costs that they are required to expend otherwise. Towards improved corporate governance reforms and increased stakeholder protection the role of institutional shareholders is also a key avenue. By requiring institutional shareholders to give regard to the interests of stakeholders, not only will the stakeholder community benefit, but it will also help in the long term success of the enterprise.

Corporate governance is the system by which companies are directed and controlled (V Finch, 1994). The initiation of Corporate Governance within the British legal framework has been an important milestone for improving the structure of the management of a company and the relationships it has with other counter-parties, but it must be remembered that corporate governance is a voluntary piece of legislation and only really impacts the largest of organisations and their executives.

Furthermore, the protection provided by the codes of best practice and the combined code do not apply to companies outside the FT350 (Financial Reporting Council, June 2006) therefore the directors of smaller companies, who are the main problem area with regards negligent decision making, do not have to abide by the corporate governance codes. Therefore as corporate governance does not provide directors with the relevant pressure to ensure proper decision making, then it can be argued that a professional qualification would at least ensure all directors have the basic level of financial understanding which would provide its own corporate governance mechanism for smaller companies.

The article concludes by indicating that the current UK legal protection measures for the interests of stakeholders are weak and emphasizes on the need to reform the current state of law in order to not only protect stakeholder interests, but also to maximize wealth creation for the society as a whole. If it can be proven that stakeholders of a company are adequately protected then it may be wise to conclude that there is no need for further reforms.

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