The impact [of Companies Act 2006, s.172]

Introduction

For global economies like the UK, a shift towards codified duties aimed at corporate governance [1] seems inevitable. Anglo-American business management practices have often been challenged for focusing on short-termism and profit maximisation at the expense of other interests – as witnessed by the recent financial crisis. So living in an era where major corporations shape the way we live our lives, the endurance of companies to sustain long-term relationships and acknowledge social responsibility is vital. Thus company directors have been long placed under pressure to encapsulate a variety of interests. The active rejection of stakeholder value gave birth to enlightened shareholder value via s.172 Companies Act 2006.

The purpose of this essay is to consider the effectiveness of s.172 in compelling directors to address stakeholder interests thus enhancing corporate governance. It will be found that while the advancement of CSR via enlightened shareholder value (ESV) is attractive and innovative, “the devil is in the detail" [2] ; the language of S.172 is ripe for misinterpretation. Directors may be morally inclined to adhere to s.172 as it will benefit the company, but the lack of adequate consequences fails it entirely.

The position of s.172

Margaret Hodge MP [3] claims that the overreaching duty of directors is to promote the success of the company (s.170). s.172 is praised for equating the ‘best interests of the company’ with primarily the collective interests of the shareholders, confirming the Greenhalgh v Arderne Cinemas Ltd [4] principle that a company is not distinct from its shareholders. Codification invites better business practices by clarifying the duty requirements. Nevertheless s.172 formulated from soft law is accused of being “the same with modern formulation" [5] , hence whether s.172 ‘develops’ the law becomes questionable. Furthermore, it is heavily criticised for not being fit for its purpose [6] while it appears to enhance CSR, the sad reality remains that no legal cure for breach is implemented. The crux of why s.172 remains highly controversial is due to the lack of adequate protection.

While ‘good faith’ mirrors the old ‘bona fide’ rule in Re Smith & Fawcett Ltd [7] , the new ambiguous concept ‘success’ concerns long term financial increase and the ultimate objective of the company. Accordingly the decision of what will promote the success of the company is for the directors’ good faith judgement. Subjectivity is possibly the downfall for this provision conferring powerful unfettered discretion to directors. Yet it safeguards business decisions undertaken as directors possess expert knowledge to make a suitable decision with good faith. Regardless, ‘good faith’ is not an absolute factor; directors must exercise their powers for a proper purpose (s.171): directors cannot exercise their power to allot shares to prevent a takeover bid [8] irrespective of good faith. Additionally, objective criteria may be introduced in interpreting s.172 through preserving common law principles under s.170(3), and by complying with their duty to exercise reasonable care, skill and diligence (s.174). Pennycuick J considered in a group context whether ‘an intelligent and honest man’ as director would reasonably believe that the transaction was for the benefit of the company [9] . However Prof. Keay notes that the subjective test in the statute will carry some weight.

This duty burdens not only executive directors but shadow directors, nominee directors and non-executive directors. The potentially broad range of liable corporate persons can seem unfair. Nominee directors further interests of the shareholder they represent, therefore fettering their discretion which may prove contradictory. It is argued that non-executive directors lack sufficient control to be liable. The law is silent in this respect.

S.172(1) Factors

These factors educate directors on the necessity of CSR, indicating that corporations do not exist in a vacuum and their actions impact a variety of stakeholders. BP’s oil well explosion in the Gulf of Mexico directly addressed the problem of CSR and demonstrated that a “corporation’s most important asset – the only one it cannot create or replace on its own – is its acceptance within society as a legitimate institution" [10] . Professor Cerioni indicates the significance of s.172(1) by paralleling them to the company’s ‘assets’ (since each factor directly or indirectly contributes to the survival of business activity). He believes long term success can be maintained by considering each factor through a strategic managerial strategy. He finds that each factor safeguards shareholders’ right to continuing income. With envisioning long term profits with better management, directors will have an incentive to adhere to the Act thus it can be a positive development as identifying constituencies as important ‘assets’ which will increase the turn-over of a company.

Prima facie stakeholder management seems to be immersed, albeit via the ‘backdoor’, granting unpoliced discretion to directors, making decision-making cumbersome and costly. The CLRSG rejected stakeholder value for such reasons, and on close reading, the provision evidently upholds shareholder value. Ss.170(3) and (4) are interesting provisions which replace pre-existing case law and require the duties to be interpreted like case law. With the flexible nature of case law, these duties can evolve with changing societal norms. The status of any principles deriving from this window is unclear since courts cannot alter statute. This can also preserve traditional shareholder value, so where a conflict arises shareholder benefit is prioritised. A recent case [11] confirms this by ruling that RBS directors did not breach s.172 by lending to companies who engage in environmentally damaging practices. Sales J rejected judicial review proceedings and felt that the directors complied with s.172 since ranking the factors is for the directors' good faith judgment, thus would be difficult to challenge. Prioritising within the list of interests is difficult. If benefitting the environment results in employees losing jobs, which factor should carry more weight? The subjective definition of ‘have regard to’ allows directors to benefit from it. Professor Alcock identifies that the difficulty in reconciling interests “almost give rise to a Catch-22 for directors [12] ". Concentrating on secondary interests leave directors open to challenge for breach of their primary duty towards shareholders, yet not upholding these secondary interests may fall foul under s.174 for lack of reasonable care, skill and diligence. Professor John thus adopts the view that companies are unique changing entities thus should be accountable to those stakeholders mostly effected by the behaviour of the company. This approach to the decision-making process would better determine what interests deserve more consideration in each case. Additionally nothing prevents directors in ‘box ticking’ or giving ‘lip service’ to the factors, thus it could act as a window dressing instrument avoiding litigation. However the s.417 Business Review compels directors to justify their decision-making therefore avoiding such acts.

Problem of Accountability

Business leaders feared that the ill-defined provision would increase litigation resulting in defensive business management practices. However in reality s.172 fails as “a right without a remedy" [13] . The Act has not codified any remedies and one is thrown back to case law under s.178(1). Additionally since directors are required to act wholly in the best interests of the company, it is the company that has locus standi to remedy a breach. Consequently on breach, only shareholders can bring a derivative claim on behalf of the company against a director (s.260). There are two problems with this; firstly a derivative action is difficult to invoke so is usually a last resort weapon; and secondly it leaves remaining stakeholders toothless against any breach.

To qualify for a derivative action, shareholders require court approval entailing many hurdles. Also a shareholders’ right to sue only arises in limited exceptions noted in Foss v Harbottle [14] . Additionally, directors will only be found liable if the company has suffered loss due to the breach of duty. Furthermore, breach under s.172 is very hard to prove, directors could easily escape liability by arguing that they had regard to the factors in good faith. This wide scope of personal assessment can create a defensive attitude, where the directors essentially use s.172 as a ‘get-out-of-jail-free-card’. Even where a claim can be proved, shareholders lack incentive to invoke this remedy since damages awarded by the courts will go to the company.

For protecting stakeholders s.172(1) has been heavily criticised. Firstly for omitting creditor interests and merely following case law under s.172(3). Thus directors only owe a duty to account creditors when financial difficulties arise. The legislature nevertheless feels that the rights of the liquidator, who enforces the duty for creditors, are sufficient in protecting their interests. On insolvency, under s.213-214 Insolvency Act, liquidators may find that the directors engaged in fraudulent or wrongful trading practises. Moreover creditor investment is protected via capital maintenance rules, ensuring sufficient funds are available to meet their investment. Yet as significant stakeholders of the company, s.172 fails to adequately protect them. An Australian case [15] emphasises that directors must account for creditor interests when discharging their duties. This duty again fails employees (previously under s.309) for having no real substance. As the social capital of a company, they are essential for its functioning. Indeed, if they are also members they can bring an action under derivative claims. Injunctive relief seems to be the only possible alternative for the constituencies in s.172(1), preventing directors from continuing their act. Yet as non-members it is difficult to see whether their claims will succeed. CLRSG confines non-member stakeholder rights outside company law: under labour law, contract law or health and safety regulations etc. Again these are imperfect ex-post safeguards - once the breach has occurred there is very little that the constituencies can do, thus ex-ante protection is necessary. S.172 fails to hold directors accountable for their actions because there may be no one able or willing to bring an action. Consequently directors may be more inclined to take a risk rather than comply. However, the true impact of s.172 lies in reading the duties together; more than one duty can apply to a breach (s.179): to exercise their powers for a proper purpose (s.171) directors must act with reasonable care, skill and diligence (s.174) and must have regard to at least the factors in s.172 [16] . The lack of case law surrounding s.172 seems to indicate that shareholders are more confident by invoking another director duty on breach.

Where a law is clear on its substance, the norm to adhere accordingly is easily created. But there are difficulties in the s.172 factors accompanied by inadequate sanctions upon breach. Hence a barrier to its proper use is inevitable. This may strengthen the Board rather than deter them from breach providing them with a get-out-of-jail-free-card. Lord Goldsmith however believes the importance of s.172(1) rests not with the issue of enforceability, but in its value as a normative function: the “long term should predominate over the short, both should be evaluated and balanced in determining what contributes best to company success" [17] . Also most corporations voluntarily engage in CSR as it serves to strengthen their reputation and increases investment in the company, e.g. Tesco’s customer focus.

Conclusion

Section 172 surfaced as a controversial duty imposed on directors; while promoting CSR via s.172 is desirable and can potentially educate directors towards change, flaws like being a ‘get-out-of-jail-free-card’ makes change seem almost utopian. Robin Hollington QC believes s.172 forces “directors to reason in a Postman Pat manner [18] . No legislation can achieve this" thus it inherently fails. S.172 appears incompatible in changing business practices and corporate governance still upholds shareholder interests shown by the recent People and Planet Case. Largely ambiguous, it is difficult to appreciate s.172 as a positive development. Nonetheless, even if the language of S.172 is ripe for misinterpretation and abuse it cannot be made redundant. The CLRSG shaped a new procedure in company law with ESV by balancing shareholder and stakeholder value. Enshrining CSR in law, Parliament maintains faith of stakeholders, and influences jurisdictions overseas (e.g. Hong Kong) to adopt something similar.

Articulating a spectrum of views, it seems that s.172 disappoints in three ways; the deficiency of clear-cut interpretation, the lack of remedial action and the absence of judicial application in the business framework. Interpretations of s.172 by the judiciary are eagerly awaited to increase our understanding of this provision, and till then our statements remain speculations.