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 wer