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Before the enactment of companies act
Does s.172 CA 2006 reflect true “enlightened shareholder value”? Critically discuss and evaluate the standard set out in s.172 in the light of the various corporate theory approaches.
Before the enactment of Companies Act 2006, there were many discussions and negotiations over the future of English company law. This act was formulated to suit the complicated issues of the companies and its members in this modern world. The difficulty faced in framing this statute was the choice of interest to be considered from the three alternatives: continuing the existing principle of shareholder value, a pluralist approach and a new regime of enlightened shareholder value. The shareholder theory requires a company to operate in order to maximise the shareholder's interests before any other interested parties who might have claims against the company. On the other hand, the stakeholder theory supports the interests of all those who can be identified as stakeholders in the company operations. In this theory, a director is expected to protect the interests of both, shareholders and stakeholders. The enlightened shareholder value notion has now been sheathed in English law, in the form of section 172 of the Companies Act 2006, as a part of new statutory framework of the director's duties. This proviso has received healthy criticism as it is impractical concept and making very less difference to the existing legal issues. It is contended that section 172(1) creates little threat to the intention of the directors on maximising profits from stakeholder relationships.
Shareholder Value Approach Versus Stakeholder Value Approach
Before moving to enlightened shareholder approach, let us analyse the two conflicting approach known as 'shareholder value' and 'stakeholder value'.
Shareholder Value Approach:
Shareholder Value regards the shareholders as the owner of the firm as they bear the risks of the enterprise. The main purpose of this approach lies in profit maximisation. This approach emplaces two important duties on the shoulders of the directors, ie, duty to perform an act with utmost care and skill, fiduciary duty. There is a statutory provision, which is even recognised at common law, that a shareholder can bring legal action in the form of derivative and personal claims against the director on his failure to discharge his duties. Many cases in this context have contributed in building a systematic body of law that seeks to protect shareholder interests. In order to protect stakeholders, there are certain provisions
in the Insolvency Act 1986 and Companies Act 1985, but they are not worth mentioning in contrast with the provisions protecting shareholders. Notwithstanding the advantages justifying the shareholder value approach, there is still room for criticizing this approach.
1) It promotes the short term gains for the company, making it difficult to sustain in the market;
2) It affects in building trust relationships with stakeholders resulting in lack of investment by them, consequently losing long-term benefits.
Stakeholder Value Approach:
In this approach, all parties which can or be affected by company's activities are included. This category consists of employees, suppliers, creditors, customers and environment. The main purpose of this approach is to recognise the interests of all above parties, irrespective of recognizing the shareholders' interests first. The supporters of this theory believe that social responsibility of a company towards environment, employees and other factors direct them to the line of success. The stakeholder value approach ensures that directors consider the interests of the shareholders along with other members of the company bearing in mind of the social issues associated with the decision-making process. Certainly, it promotes the company with long term success by inducing social responsibility. The company adopting evil practices such as sweatshops or child employment would attain short term profits but would fail to establish their long term goodwill in market. As a matter of fact, gratuitous attention on shareholder value to reap instant gains may suppress the long term success and it would just seem to be a path to success. The company's share-prices may be at peak in spite of their weak performance but would crash down if the capital is expended on new research and technology to increase its future potential. There are some factors which has entailed United Kingdom to consider the stakeholder value strategy such as institutional investors, pressure from European Union, UK Government initiative to avoid corporate scandals and last but not the least, the influence of the Company Law Review. There are few shortcomings to this approach also which are detailed as follows:
it would be difficult for the director to distinguish between the genuine competing interests of the different stakeholders;
Evaluation of director's performance is a major problem;
This approach insist to place restriction on shareholder control;
It distracts the director's focus on maximising shareholder value. (Fisher, 2009)
The pluralist approach was considered and subsequently rejected by CLRSG on the grounds that the law would require some complicated modifications like considering wider range of interests, not subsidiary or as means to achieve shareholder value, but an recognition as an independant claim. The CLRSG were of the view that this approach would fail to fit in the English system and considered it to be impracticable theory in UK. Recently, Professor Michael Jenson advocated the enlightened value maximisation principle, which is similar to ESV concept, and stated:
"It is obvious that we cannot maximise the long-term market value of an organisation if we ignore or mistreat any important constituency. We cannot create value without good relations with customers, employees, financial backers, suppliers, regulators, communities, and so on".
The vision of the above analyst greatly influenced the CLRSG's reports and recommendations for the codification of the provision for director's duties. (Keay, 2007)
Before the enactment of Companies Act 2006, the common law had given an edge to the director's duties, by designing a fiduciary duty of a director to act in good faith believing it to be in the interests of the company, in order to maximise the interests of shareholders above those of other parties with their prospective claims by concentrating on share value and short-term profit. There was an additional duty conferred on the director to consider the interests of the creditors where the company was insolvent or of uncertain solvent condition. Section 172 of the new act fabricates the language used in section 309 of the Companies Act 1985 which requires the directors to have regard to the interests of the company's employees in most cases. (Hannigan, 2003)
Enlightened Shareholder Value
"Section 172 : Duty to promote the success of the company
A director of a company must act in the way he considers, in good faith, would be most likely to pormote the success of the company for the benefits of its members as a whole, and in doing so have regard (amongst other matters) to-
the likely consequences of any decisions in the long term,
the interests of the company's employees,
the need to foster the company's business relationships with suppliers, customers and others,
the impact of the company's operations on the community and the environment,
the desirability of the company maintaining a reputation for high standards of business conduct, and
the need to act fairly as between members of the company.
Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefits of its members were to achieving those purposes.
The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company". (Section 172 of Companies Act 2006)
Interpretation Of Section 172 Of Companies Act 2006
Sub-section (2) is undoubtedly fabricated to protect the status of non-commercial objectives featured in the case, Horsley & Weight. Sub-section (3) sustains the position of creditors by reinforcing the consideration of directors in certain circumstances. (Alcock, 2009)
After the enactment of s.172 in the UK Companies Act 2006, it was perceived at first instance that it was a remarkable change from the common law duties. But later, it was discovered that it was a modification of earlier piece of legislation. The introductory statement of section 172 is debatable, as it seems like re-statement of the existing common law duties. The conception that the ESV is different in its approach as compared to other corporate theories, reveals the fact that it is not remarkably different from the shareholder value principle in the matter of determining director's duties, in spite of broad consideration received by the UK courts. (Yap, 2010)
The first case to interpret the provision of director's duties was the Scottish case of ‘Re West Coast Capital (Lias) Ltd'. In this case, Lord Glennie regarded the provison of section 172 as a replacement of common law duties and previous equitable principles. According to him, section 172 compels the directors to consider the interests of the stakeholders
while discharging the duty to promote the success of the company. The most controversial issue of the Companies act 2006 was the codification of director's duties. Some criticised
the view to consider the interests of stakeholders whereas some believed that the flexible nature of common law duties would be affected by the codification. (Goddard, 2008)
This fiduciary duty of directors was asserted by Lord Greene MR in the case ‘Re Smith & Fawcett Ltd', that it is the duty of the director to exercise the power conferred upon them ‘bona fide in what they consider - not what a court may consider - is in the interests of the company'. This section enacted in the companies act 2006 can be reflected from the CLRSG's principle of ‘enlightened shareholder value' even though the final outcome is different from the draft attached to their Final Report and the previous legislations. (John Birds, 2009)
The main reason for making a change in Company law was that the existing common law dealing with the director's duties was inefficient in guiding the directors with regards to choosing the interests while dicharging those duties. At common law, the requirement of those who can claim to act or on behalf of the company can enforce the duties seems to be pointless, because the company is an artificial legal person and it is not possible to assign interests to it. This shows the clear intention of the drafters of the statutory statement of section 172 which indicates the omission of the reference of ‘interests of the company' and the preference to be given to the shareholders and other members by the directors in discharing their discretion. (Davies, 2008)
Criticism Of Enlightened Shareholder Value
The ‘Enlightened Shareholder Value'(ESV) approach was criticised on the grounds that if the management of the company organize the business in such a way that the employees of a company are reluctant to work efficiently, the suppliers and customers are unwilling to trade with it, it is deviant within the community it exists and it is unfavourable to the ethical and environmental standards, then that policy is not likely to endorse the interests of the shareholders. However, it can be deduced the interests of the employees and stakeholders are protected by the directors only while promoting the sucess of the company for the benefit of its members. There is no independant value for the non-shareholder interests with regards to director's duties, as it exists in the pluralist approach.
The ESV approach was just a modified version of common law which only entitled the directors to consider the stakeholder interests while discharging their duty towards the interests of the members. Bowen L.J. said with reference of ultra vires, “The law does not say that there are to be no cakes and ale, but there are to be no cakes and ale except
such as are required for the benefit of the company”. Later, it was argued that section 172 imposes a very low standard for directors. So it can be described as a subjective provision as there is limited scope of enforcement in the proceedings, which was similar to the problem in common law as to the enforcement of duty of loyalty. The literal words of section 172 suggest a subjective standard, which is vague to implement. Finally, section 172 does not exempt the company to comply, for example, with health and safety or discrimination legilation, irrelevant of company's success. (Davies P. , 2008)
It is interesting to note that the section 172 of Companies act 2006 has received several criticisms. The first of all is the question with regards to stakeholders that what remedy is available with the stakeholders if the directors overlook their interests in discharging their duties, as “a right without a remedy is worthless”. Except for the members, other stakeholders mentioned in section 172 have no right to take legal action against the directors. Thus, the status of such stakeholders seems to be on the verge of downgrade. The intent behind framing this section was to strike a balance between the traditional shareholder value apprach and the pluralist approach. But in reality, the interests of other stakeholders are not well-protected as compared to that of the members. Secondly, this modified version of the previous act still shows the impression of common law rules as it can be noticed from the fact that in spite of the duties inserted in section 172, there would be a need to refer the precedents for remedies as against a breach of those duties. The section 172(1), as such, does not include any provision for the interests of creditors. It has been considered in section 172(3) which provides that,“The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company”. This can be traced in the common law rules requiring the directors to act in the interests of the creditors when the company was insolvent or of uncertain solvent state. In broad sense, the rationale behind formulating the director's duties in section 172 is to make those duties simple and readily available to the layman. The main purpose was to serve the directors to determine their duties and penalties for breach by simple access to statutory provisions, instead of refering the large volumes of case law. (Yap, 2010)
The major drawback of shareholder-centred approach was that it excluded women representation on the grounds that men are more appropriate in maximising profits proved in past history. It is argued that female under-representation at board level is a negative aspect of this theory. Belcher asserted in this context that, “masculine and feminine characteristics often appear as binary oppsitions” suggesting that “stereotypically feminine traits are associated with incompetence”. (Wesley-Key, 2007)
There was a debate on the issue of section 172 demonstrating the ‘enlightened shareholder value' principle which commenced with the argument that shareholders do not have effective control over the company, indirectly the directors are not bound by them. So it proves that the directors are not held liable, everytime they fail to promote shareholders wealth maximisation. The second point is that limited shareholders derive benefit from this principle and all stakeholders will suffer because of company's failure to fulfill its obligations. This principle helps some investors to gain short-term benefits, but in long run it proves to be a failure for other investors causing financial uncertainty. There are many other persons in line with shareholders to be affected by the company's decisions. Certain employees who are skilled in certain field have taken special risk for the firm and should be residual claimants. It was suggested that profit maximisation should not be the only stimulating aspect of director's duties in section 172. There is a clear sign of support towards the shareholder value principle in English law, which can be traced from the famous 1951 case "Greenhalgh v Arderne Cinemas Ltd". In spite of this proposition, Greenhalgh v Arderne Cinemas Ltd is a bad law for various reasons enumerated as follows:
The issue of corporate objective was left untouched;
The judgement of the Court of Appeal lacks pratical application;
It put emphasis on protecting shareholders' interests, whereas many other modern cases consider that directors are duty-bound beyong those owedd to shareholders;
The primary objective of section 172 lies in director's duty to promote the success of the company for the benefit of the shareholders. After accomplishing this objective, follows the secondary objective to regard the stakeholders' interests. Moreover, the stakeholders lack
the right to sue the director in case of failure to consider their interests. At first instance in English law, this provision seems to follow the stakeholder value approach instead of shareholder value but the intense scrutiny proves something different. Therefore, this section has led to debate whether it supports shareholder value or stakeholder value approach. (Attenborough, 2009)
The main notable point is that there does not seem to be any structure in place to ensure that directors are liable for their decision-making process. A failure to consider certain specified matters of s.172(1) should be considered as breach of duty to promote the
success of the company. The Explanatory Notes fail to place the liability on the director while neglecting those matters in promoting the success of the company.
"The duty does not require a direcctor to do more than good faith and the duty to exercise reasonable care, skill and diligence would require, nor would it be possible for a director acting in good faith to be held laible for a process failure which would have affected his decision as to which course of action would best promote the sucess of the company".
Finally it was concluded in this article that while codifying the director's duty to act in company's interest, the Hong Kong Government should consider more traditional approach of Australia and New Zealand rather than ESV approach of UK. (Wu, 2010)
The supposition of the Law Society is that, "the new code is inflexible-at present, the courts have considerable freedom to develop the law on director's duties to suit changing needs and expectations and in practice the code will not be more accessible than common law rules, as its meaning will over time become less and less clear to a reader who does not also understand how it has been interpreted and applied by the courts". However, untill there is scarcity of case laws in this context, the debate and confusion will continue to prevail over the interpretation of s.172. Mrs Hodge states that the new ESV approach is the combination of shareholder value and stakeholder approach thus promoting development and evolving social responsibility. It is still not feasible to place "non specific mandatory burdens on company directors", which could give rise to uncertainity and fear of litigation. (Nakajima, 2007)
Response Of The Secretary Of The State Towards The Crticism Of Esv
In order to suppress the above criticism of ESV approach, the Secretary of State proposed to consider the requirement that directors produce an annual report for each financial year,
which is most accessible by the public. There is a provision in this context, inserted as s.417 of the Act, which describes the director's duty to produce such report, which contains detailed information regarding the performance of their duty to promote the success of the company. It also includes information that a company must state includes information of environmental matters, the company's employees and social and community issues. With the help of this report, each member of the company can supervise the activities of the directors. It even helps shareholders and consumers to be open-minded in making their choices. Notwithstanding the censure of ESV concept, if consumers and investors believe in a company and prefer them as compared to others, then those company's shares-value increases.
There are many controversies in relation to this legislation that failure to implement this duty except by the members of the company may result in rare use of this provision in judicial courts as similar as the existing statutory provision for the employees. Others are of view that this provision entails the burden of personal liablity on the directors. But a significance of this provision lies in the potential transperancy on such issues with the help of annual director's report. Finally, the success