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Modernising company law

1 October 01

How the company law review might impact on directors’ duties and remuneration

by Alison Keith

In March 1998 the Government launched a review of company law in Great Britain with the objective of modernising company law to provide a simple, efficient and cost effective framework for business activities. The final report of the company law review steering group (“CLRSG”) “Modern Company Law for a Competitive Economy” (“the Report”) was issued on July 26, 2001. The report is wide ranging and covers, inter alia, corporate governance, the role of directors, shareholder rights, capital maintenance and the registration of company charges.

In this article, the writer proposes to concentrate on two inter-related topics:

1. the duties incumbent on directors identified in the Report; and

2. directors’ remuneration.

The duties and obligations imposed on directors at common law and under statute are myriad and complex. An overhaul of this area of the law is long overdue both from the perspective of the lawyer and that of the lay director seeking to comply with those duties and obligations. Allied to that is the increasing emphasis placed by shareholders on the stewardship function of directors and the often-perceived conflict arising between that and remuneration.

Current Position

Prior to considering the Report’s proposals in relation to directors it is helpful to consider the current position.

The duties incumbent on directors at the moment, can be broadly divided into:

(1) fiduciary duties;

(2) duty of care;

(3) part X of the Companies Act 1985 (“the Act”);

(4) other statutory duties; and

(5) the special situation arising under insolvency

One of the leading explanations of fiduciary obligations is that given by Millett LJ in Bristol & West Building Society v Mothew which was recently approved by the privy council in Arklow Investments v Maclean.

Millett LJ identified the obligation of loyalty as the distinguishing obligation of a fiduciary and noted:

“The principal is entitled to the single-minded loyalty of his fiduciary. The core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trusts; he must not place himself in a position where his duty and his interests may conflict; he may not act for his own benefit or the benefit of a third person without the consent of his principal. This is not intended to be an exhaustive list; but is sufficient to indicate the nature of fiduciary obligations. They are the defining characteristics of a fiduciary.”

Directors must act with appropriate care in discharging fiduciary obligations. Romer J in Re City Equitable Fire Insurance Company expressed a subjective standard of care:

“A director need not exhibit in the performance of his duties a greater degree of skill and knowledge than may reasonably be expected of a person of his knowledge and experience.”

Arguably, the position has changed considerably since that judgment was given in 1925.

The position now is that directors must exhibit the degree of care of a reasonably diligent person having both:

(1) the general knowledge, skill and experience of a person carrying out that director’s functions; and

(2) the general knowledge, skill and experience of the director himself.

The fiduciary duties and consequent duty of care owed to the company are, in broad terms, owed by the directors to the shareholders of the company. In general, this does not include creditors, individual shareholders or a particular body of shareholders. A director’s focus extends (where a company is operating in circumstances of doubtful solvency) to include consideration of the interests of creditors. The difficulty for directors has long been in understanding the point at which the balance shifts in the duty owed to the company and when the interests of creditors become a factor for consideration. This can be particularly acute in the case of small to medium sized private companies where directors and shareholders are often common and creditors are the main third party group interested in the company’s fortunes. This broad statement is also tempered by the terms of section 309 of the Act which imposes an obligation on directors to have regard to the interests of the employees of a company as a whole.

This latter provision has been subject to some criticism, firstly, on the basis that there is no attempt to resolve the potential conflict between the interests of employees and the interests of members and, secondly, the employees have no direct ability to enforce this duty.

Increasingly, directors can find themselves facing personal liability. Directors can be held liable to contribute to a company’s assets in circumstances of insolvency where wrongful or fraudulent trading has occurred. Similarly, a number of statutory provisions now seek to impose personal liability on directors.

It is against this background and keen and continuing public interest in directors’ remuneration that the Report was produced.

The Report

Chapter 3 of the Report deals with internal governance and external regulation. It notes that the three core policies at the heart of the review have been:

1. “think small first”;

2. an open, inclusive and flexible regime for company governance; and

3. the appropriate institutional structure for law and other rule making and enforcement.

The “think small first” strategy is appropriate given that of all the companies registered as at March 31, 1999, there were over 1.2m private companies limited by shares compared with 11,600 public companies. 65% of live companies had a turnover of less than £250,000. 70% of companies had only one or two shareholders. Approximately 76% had 9 or less employees. Any review of company law accordingly had to focus on the interests of the majority of companies while still remaining suitably relevant for public companies and for the larger private companies. It is, however, debatable to what extent the formulation of directors’ duties produced is appropriate to small private companies as opposed to large listed companies.

The Report regards the last two core policies as closely related and indicates that the proposals on governance involve allowing a very large measure of freedom in the arrangements for controlling and organising the operations of a company’s business within a realistic and, importantly, inclusive decision making framework. The report regards the onus on shareholders as heavy and indicates that for this approach to work, shareholders need:

“timely and high quality information to enable them to assess the performance of the company and the directors’ stewardship of the assets”.

It is interesting to seek to identify in whose favour CLRSG regards companies as being run. The two principal schools of thought are the “enlightened shareholders value” theory and the “pluralist” or “stakeholder” approach.

The enlightened shareholder value theory gives primacy to shareholders’ interests but requires directors to take decisions in an inclusive fashion to recognise best practice in relation to a broad range of interested groups (including, for example, employees). It is broadly reflected in traditional company law.

The pluralist theory considers that companies should be run in a way which maximises wealth and welfare for all and does not give inevitable primacy to shareholders. Shareholders are seen as only one of a number of stakeholders which includes employees, customers, local communities, etc. and requires company law to at least permit directors to give priority to one of these groups at the expense of shareholders if justified by circumstances. CLRSG had previously indicated that it had decided against imposing pluralism in the sense of allowing directors a discretionary power to decide other interests should override those of shareholders.

CLRSG regards provision of a statement of directors’ duties as being a key proposal to encourage improved company governance and notes that there is wide demand from company directors for clarity on what the law requires of them. Although case law already sets out the rules applicable to directors in the form of the fiduciary duties owed to a company, CLRSG is concerned that the duties in their present form are “widely misunderstood, and unclear or imperfect in a number of areas”.

There has been some discussion as to whether such a legislative statement would or would not be advantageous. CLRSG considers that a legislative statement would be beneficial in that:

1. it would provide clarity and make the law more accessible;

2. it would enable defects in the present law to be corrected in important areas (particularly identifying the duties of conflicted directors and the powers of the company in respect thereof); and

3. it is a key element in addressing the question of in whose interest companies should be run in a way which reflects modern business needs and wider expectations of responsible business behaviour.

The pluralist approach appears evident in that the proposed statement of duty of loyalty for directors sets a basic goal for directors of ensuring success of the company in the collective best interests of the shareholders but requires them to recognise the company’s need to “foster relationships with its employees, customers and suppliers, its need to maintain its business reputation, and its need to consider the company’s impact on the community and the working environment.”

The draft statement of directors’ duties annexed to the Report comprises a proposed clause for insertion into a new Companies Bill and a schedule restating the principal duties. The draft clause indicates that the schedule sets out the general principles applying to a director of a company in the performance of his functions as director; the general principles applying to a director entering into transactions with the company and applying to a director or former director in relation to the use of property, information and opportunities of the company and to benefits from third parties. This is specified as being in place of the corresponding equitable and common law rules. Directors are to owe a duty to the company to comply with the whole schedule while former directors are to owe a duty to comply with paragraphs 6 and 7. Broadly, the general principles by which directors are to be bound are as follows:

1. A duty to obey the company’s constitution, to act in accordance with decisions taken under that constitution and to exercise powers for their proper purpose.

2. A duty to act in the way he decides in good faith is most likely to promote the success of the company for the benefit of its members as a whole and in making that decision to take account of all “material factors” that it is practicable in the circumstances for him to identify.

These material factors are described as the likely consequences of the actions open to the director, so far as a person of care and skill would consider them relevant and all such other factors as a person of care and skill would consider relevant including such of the following matters as he would consider so:

(a) the company’s need to foster its business relationships, including those with its employees and suppliers and the customers for its products or services;

(b) its need to have regard to the impact of its operations on the communities affected and on the environment;

(c) its need to maintain a reputation for high

standards of business conduct; and

(d) its need to achieve outcomes that are fair as between its members.

3. Not to delegate powers or fail to exercise independent judgment in relation to an exercise of powers unless expressly authorised to do so.

4. A duty to exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both:

(a) the knowledge, skill and experience which may reasonably be expected of a director in his position; and

(b) any additional knowledge, skill and experience which he has.

5. A duty to avoid conflicts of interest.

6. An obligation not to use any property or

information of the company, or any opportunity of the company which he became aware of in the performance of his functions as a director unless agreed to by the company.

7. A duty not to accept any benefit conferred because of his power as a director unless agreed to by the company or if the benefit is necessarily incidental to the proper performance of his function as a director.

8. A special duty where the company is “more likely than not” to be unable to meet debts. This is listed in square brackets as CLRSG was unable to reach agreement on its inclusion or extension.

9. A special duty on directors where there is no reasonable prospect of avoiding insolvent liquidation specified as applying where a director knows or would know (but for a failure to exercise due care and skill) that there is no reasonable prospect of the company avoiding going into insolvent liquidation. In these circumstances a director must take “every step” with a view to minimising the potential loss to the company’s creditors that a person exercising due care and skill would take.

CLRSG consider that the format of clause, schedule and explanatory notes is advantageous in that it provides flexibility in the structure of the statement and allows materials to be included at different levels. This is intended to make the statement more accessible for all kinds of user. This is intended to be included in Part 1 of the proposed bill which also includes provision requiring the first directors of a company to confirm, at formation of the company, that they have read the statement. A similar requirement is to be included on subsequent appointment of directors. The clause is drafted in such a way as to make it clear that the principles impose obligations owed to and enforceable by the company alone. The replacement of the existing common law and equitable rules is intended to ensure that the statement of principles contained in the schedule is exhaustive.

The emphasis on directors taking account of ‘material factors’ in the decision making process is borne out by the provision in the Report for companies of a particular size to be required to publish, as part of their annual report and accounts, an operating and financial review (“OFR”) to cover the company’s business, performance, plan and prospects.

The concept of corporate social responsibility is, of course, a hot topic at the moment. More emphasis is now given to ethical investment in the personal financial pages. The FTSE4Good (a new index series for socially responsible investors) was launched at the end of July.

CLRSG is concerned with empowerment of shareholders and appropriate levels of transparency. They indicate that they are concerned with public and large private companies where the economic and wider community impact underlines a need for greater transparency. The OFR proposed by CLRSG is to include certain mandatory items, those being the company’s business, strategy and principal drivers of performance; a review of the development of the company’s business over the years and the dynamics of the business, including events, trend and other factors which may substantially affect future performance. It can also contain information on corporate governance, relationships with employees, customers, suppliers and others on whom the company’s success depends and on environmental, community, social, ethical and reputational issues. CLRSG indicate that it is for directors to decide which issues are relevant for inclusion. CLRSG considers it to be counter-productive to include a mandatory list of items as it would force boiler plate reporting and recognises that the credibility of the discretionary OFR structure will depend on an appropriate level of auditor review.

The exact threshold of the size of entity to which this will apply is suggested as including public companies which satisfy at least two out of three criteria of having a turnover in excess of £50m, a balance sheet total in excess of £25m and a number of employees in excess of 500 and for private companies the corresponding threshold should be £500m, £250m and 5,000.

The recommendation is that the DTI consider those thresholds and set them.

Remuneration

The emphasis in chapter 3 of the Report is on empowerment of shareholders in particular in relation to decision making, duties and corporate social responsibility. The other area affecting directors which has attracted a great deal of comment is in relation to directors’ remuneration. Vodafone are currently reviewing their directors pay packages after over 40% of their investors opposed or abstained on a resolution to approve directors’ remuneration. The resolution concerned sought to approve bonus schemes whereby the company’s chief executive could have become entitled to £12m worth of share options. The Association of British Insurers (“ABI”) earlier this year published consolidated guidelines on share incentive schemes. Those guidelines endorse the growing trend towards phased annual grants of options or shares and a sliding scale for remuneration relative to performance. The ABI has stressed that companies should be trying to encourage executives to build up and retain a shareholding in their company to align interests of management and shareholders.

The ABI guidelines require companies to demonstrate a demanding level of compliance. In particular, remuneration committees must possess an appropriate level of independence and objectivity and be able to show that they have had regard to the ABI guidelines. The guidelines also recommend that companies disclose full details of share incentive schemes to shareholders and the effective cost to shareholders operating those schemes.

In March this year, the Department of Trade and Industry issued a press release detailing plans to introduce new disclosure requirements on boardroom pay designed to strengthen both the position of shareholders and the link between pay and performance.

This contained details of proposed secondary legislation which would require quoted companies to publish a report on directors’ remuneration as part of the company’s annual reporting cycle and disclose certain matters within the report including details of individual directors’ remuneration packages. The DTI release identified “an obvious conflict of interest in relation to directors’ remuneration” and this as an area where it is important for shareholders to be actively engaged.

The Greenbury report (and Hampel in its turn) perceived the way forward as lying not in statutory control but in action to strengthen accountability and encourage enhanced performance. Strengthening accountability lay in proper allocation of responsibility for determining directors’ remuneration, proper reporting to shareholders and in transparency. Greenbury identified that the board of directors needed to delegate responsibility for determining executive remuneration to a group of people with knowledge of the company but no personal financial interest in the remuneration decision taken. It placed importance on an obligation to submit a full report to shareholders each year explaining the company’s approach to executive remuneration and providing full disclosure. Part of the issue for shareholders (of particularly the large plcs) has been the perceived conflict of interest (and consequent breach of fiduciary duty) in directors determining their own pay and a further perception that directors are not acting in good faith in relation to these points. This arises, in particular, where large pay awards have been made. A common perception is that the directors in these instances are not fulfilling the stewardship function incumbent on them in diverting large proportions of the company’s assets to themselves.

It is, of course, important that companies invest in remuneration packages which retain and motivate people of the right calibre and experience for the company. A great deal of interest is being expressed in linking reward to performance. Both the Greenbury and Hampel Reports recognised that directors’ remuneration is of legitimate concern to shareholders and provided that shareholders should be invited specifically to approve all new long term incentive schemes on the basis that they relate to performance over a series of years and potentially commit shareholders’ funds for more than one year ahead or dilute the equity. The London Stock Exchange Listing rules already containing such a provision.

Certainly part of the CLRSG proposals for greater transparency should, if adopted, assist in this area.

Conclusion

Given the public interest in the areas of directorial control and duties, the Report appears to have correctly identified some of the principal areas of public concern. The European Commission has recently presented a green paper promoting a European framework for social responsibility in business with an aim of launching a debate on how the European Union can create a framework for corporate social responsibility. The outcome of this consultation is due to close on December 31, 2001.

It will be interesting to see whether:

(a) the new Companies Bill accurately reflects these proposals and sets the right tone for companies going forward;

(b) the proposed statutory

statement of directors’ duties achieves its aims of clarity and accountability; and

(c) directors’ remuneration does become more tightly controlled and, consequently, shareholders become happier.

Alison Keith is a senior associate in the corporate group of MacRoberts in Glasgow.