An Agency Perspective of UK Company Law

Introduction

The UK model of the corporation is essentially an agency between the shareholders (principals) and the executives (agents). [1] Correspondently, the central aim of the company law is to tackle the agency problem hence occurred. As we will see in this essay, the UK lawmakers have devised various strategies under the company law regime to address the problems of management incompetence and self-seeking. To a certain point, these strategies have worked to their effect. Nevertheless, more efforts are needed to reduce the agency costs.

The essay is organized as follows. Section II provides some basic background of company law’s role to minimize agency costs. Section III assesses the effectiveness UK company law has achieved to tackle the shareholder-executive agency problem by focusing on the governance strategies and regulatory strategies employed by UK lawmakers in turn. Section IV draws some conclusions.

Agency cost and company law’s central objective

The separation of ownership and control is perhaps one of the most fundamental characteristics of corporate Britain. By allowing professional managers to run the business while attracting public investors who have neither interest nor expertise to control the day-to-day management, it greatly increases the company size and facilitates its productivity. [2] Meanwhile, this key feature has also engendered the principal-agent problem. Executives (agents) usually lack the incentives to operate the firm as efficiently as shareholders (principals) have expected, and tend to divert the corporate resources for their own benefit. [3] On the other hand, with the growth of corporate size and the complexity of business, direct monitoring by individual shareholders (who also face the collective action problem) becomes increasingly difficult. Hence, the divergence between the interests of the principals and the agents has given rise to agency costs. In their groundbreaking work ‘Theory of the Firm’ Jersen and Meckling identified three components of agency costs:

the supervision and control resources diverted by the principal, referred to as monitoring costs;

bonding costs borne by the agent to convince the principal of her long-term commitment; and

residual loss arising from the principal and agent’s conflict of interests, despite the mechanisms of monitoring and bonding. [4]

One of the key roles company law plays is to minimise these agency costs. According to Kraakman et al, the legal strategies employed to reduce agency costs can be divided into two categories: governance strategies and regulatory strategies. [5] In corporate context, governance strategies, or principal-empowering strategies, aim to facilitate principals’ control over agents by means of shareholder empowerment; while regulatory strategies, or agent-constraining strategies, seek to regulate agents’ behaviours. [6]

How effective does UK company law achieve the goal

Governance strategies

Appointment of the board and rights to intervene with the management

The cost for individual shareholders to supervise executives directly would be too high, hence the board as a monitoring intermediary is devised to reduce the agency cost. Shareholders’ rights to select and remove directors (‘appointment rights’) and their power to intervene in the company’s management (‘decision rights’) are among the most important strategies the law has employed to address the shareholder-manager agency problem. [7]

Apart from a few requirements such as directors’ minimum number and age, UK company law is quite silent on the boardroom appointment. [8] The law seems to leave the issue to the corporate constitution. The model articles for public and private companies both suggest that shareholders in general meeting have the inherent power to appoint directors by ordinary resolution. [9] However, under the current legal regime, shareholders’ control over the appointment process is quite limited and they could even ‘be wholly written out of the appointment process’, as it is not against any mandatory law for the articles to include clauses such as existing directors could decide upon successors of resigned or removed directors without shareholders’ approval. [10]

The similar approach is also adopted in respect with the distribution of power between the general meeting and boardroom. Companies Act 2006 (CA 2006) is again far from prescriptive in providing the respect roles of shareholder and director, but leaving them to the articles. In practice, the power of management and control of the company usually lies with the board, except for certain important decisions reserved exclusively to the shareholders as are provided by law or the articles. [11] Therefore, directors tend to enjoy a wide range of management power, and may even act against the wishes of shareholders. [12] Indeed, once the articles has vested the management power with the board and as long as directors act within power, the general meeting can no longer interfere with the business operation by giving directors binding instructions. The rule is expressed in Shaw & Sons (Salford) Ltd v Shaw where Greer L.J. noted that:

A company is an entity distinct alike from its shareholders and its directors. Some of its powers may, according to its articles, be exercised by directors, certain other powers may be reserved for the shareholders in general meeting. If powers of management are vested in the directors, they and they alone can exercise these powers. [13]

The only way for shareholders to intervene is by altering the articles, or by removing the directors. Although CA 2006 says very little about the boardroom selection, it plays a crucial part in setting the rules regulating the removal of directors. [14] Under s 168, shareholders may remove a director by ordinary resolution before the expiration of his period of office, notwithstanding anything in any agreement between him and the company. The power of removal may be of little meaning in the sense that the disgruntled shareholders are still unable to invalidate a decision that the directors have previously taken, but the mere threat to dismiss a disobeying director seems to be enough to make the directors following shareholders’ instructions. Only the problem is, when the dispersed individual shareholders have been reduced to a routine rubber-stamp of the directors’ recommendations, [15] are they able to act collectively to give instructions?

In addition, it is also doubted that to what extent the power to outset directors could work effectively given the possibility of director entrenchment. Directors of private companies may adopt a number of techniques such as weighted voting to make them irremovable. [16] Public companies, though prohibited to adopt weighted clauses, may also face high damages of breach of contract subject to the service agreement of the director. [17] UK company law addresses the issue by requiring prior disclosure and approval of directors’ severance pay. [18] S 412 now requires that the annual accounts disclose the aggregate emolument of the directors, including the pensions for present and past directors and directors’ compensation for loss of office. [19] However, despite the legal provisions and government’s appeals and efforts, ‘golden goodbyes’ for directors of failing companies remains one of the anxieties of corporate governance in UK.

Shareholders’ voting rights

Another major topic of shareholder empowerment is the shareholders’ ‘voice’ in the general meeting. The practical importance attached to the general meeting has been greatly reduced—in small companies the shareholder meeting has become unduly burdensome, while in big companies, the attendance rate is very low. [20] Members who do attend are often not representative and the discussion is often used by campaigners with the intention to gain publicity for their own agendas. [21]

In UK a number of attempts have been made to address the issue and to create a ‘more effective machinery for enabling and encouraging shareholders to exercise effective and responsible control’. [22] The system of proxy voting and the facilitation of electronic communication both have worked notably to encourage shareholders to express their views through general meetings. However, more efforts could have been made to turn the meetings into more valuable events. For instance, the law now gives members holding together at least 5% of the company’s shares (or minimum of 100 members holding shares on which an average of ￡100 has been paid up) the right to have a statement circulated. [23] The positive effect of the provision to provide opposing shareholders chances to have their say should not be neglected, but considering the considerable cost related with the statement circulation which shall be borne by the relevant members, the provision seems have limited value in practice. [24]

Executive reward as the reward strategy

Aligning the interests of shareholders and the executives through the use of performance-related pay packages is a widely-used device to mitigate agency costs. The law usually plays an indirect role into the reward strategy and UK company law is no exception. [25] However, due to the increasing concern of rapid growth of the executive payment, UK law has aimed to curb excessive remuneration packages by granting shareholder more powers. CA 2006 requires (a) that the directors of a quoted company must prepare a directors’ remuneration report for each financial year; [26] and (b) an advisory vote by the shareholders on the report, [27] consolidating the requirements under the Directors’ Remuneration Report Regulations 2002. [28] Although the directors could continue to receive the relevant remuneration package despite an adverse vote, they usually tend to move quickly to amend the contentious remuneration arrangements. [29]

3.2 Regulatory strategies

Directors’ duties and ex post enforcement

It is observed by Davies that the approach adopted by UK company law to address the principal-agent problem is to ‘allow companies maximum freedom to decide on the divisions of powers between shareholder and board and on the functions of the board, but then to concentrate on the regulation of the way the board discharges the powers conferred upon’. [30] Indeed, rules and standards under legal framework with the function to constrain directors’ behaviour are perhaps more attractive since the successful enforcement of governance strategies is faced with the challenge of high coordination costs. [31]

The most familiar constraint strategies under UK company law are legal duties imposed on directors, which were developed by the courts of equity and recently codified in CA 2006 with the view that the restatement of directors’ duties in statute would make the relevant rules clear and accessible. [32] There were concerns that the codification might lead to inflexibility in the law, however, according to the Law Commission, the issue could be addressed by expressing the statutory rules ‘at a high level of generality’ and by stating that the duties under CA 2006 are not exhaustive hence allowing the court to develop new principles. [33]

It is still debatable whether these substantive duties under the new act are more or less constraining of directors than they were at common law. Those with the opinion that the statutory duties impose stricter duties usually cite the duty of care to support their view.

Historically, the English jurisdiction embraced a relatively low standard of directors’ duties of care. This could be reflected from the ‘subjective test’ used to be adopted by the court in directors’ negligence cases. However, echoing the recent trend of common law, CA 2006 includes an objective assessment of a directors’ behaviour. [34] The statutory statement contains two limbs: s 174 (a) sets out an objective standard which applies to all the directors and (b) adds a subjective standard by which the level of care required of a particular director could only be increased. [35] Hence it is suggested directors are subject to higher standard of duty of care under the current regime of company law. However, given the judges’ traditional unwillingness to interfere with executives’ business judgment in the absence of any conflict of control, few believe this will ‘lead UK courts to second-guess business decisions’. [36]

There are also people who believe the statutory duties are more in favour of the directors than previously. [37] One of the arguments is that prior approval by non-involved directors which may release directors from their duties now also applies to corporate opportunities and other conflicted situation. [38] However, whether the independent members of the board could exercise ‘a genuinely independent judgment’ and be relied upon to guard the shareholders’ interests are rather doubted. [39]

In addition to the ex ante rules imposed on directors, ex post strategies are also adopted by UK company law through both public and private enforcement. The most intensive public enforcement in UK is perhaps the disqualification regime under the Company Directors Disqualification Act 1986. The Secretary of Sate for Trade and Industry may apply to the court for a disqualification order banning relevant individuals from acting as directors. [40] In spite of the wide use of the regime, the practical consequences of the disqualification provisions have been limited. [41] Nevertheless, it is believed the regime could have a substantial impact of regulating directors’ behaviour. [42]

On the other side is the private enforcement. [43] The civil remedies for breach of directors’ duties are not codified but remain with the common law. [44] The remedies are thought as powerful and stringent. [45] In cases such as Regal (Hastings) Ltd v Gulliver, directors were held liable even where they acted honestly and the company could not otherwise have obtained the benefits. [46] The English courts have also adopted the concept of ‘constructive trust’ which allows the company to recover its property in the hand of a third party recipient due to the director’s breach of duty. [47] ‘Exacting standards’ and ‘an extensive liability’ are considered important so as to ‘provide an incentive to fiduciaries to resist the temptation to misconduct themselves’. [48]

Despite the failure to codify the remedies for breach of directors’ duties, CA 2006 provides for a contentious reform of derivative claim. [49] The common law framework was long criticised of not providing an effective weapon for disgruntled shareholders to bring actions against the company’s directors. The cause of action has been broadened under the new statutory provision, and it is now easier for individual shareholders to bring derivative actions. However, the court’s traditional reluctance to meddle with the company’s internal management and the high procedural threshold provided by the new act may indicate that the balance is still in favour of directors. [50]

information disclosure

Among various preconditions underlying the success of regulatory strategies, an effective information disclosure mechanism is perhaps the key one. [51] Without suffice information, it would be impossible for the principals to identify any misbehaviour on the part of the agents. Another important function of information is to facilitate an informed and efficient market pricing system so that shareholders could have a fair view of the company’s financial position. [52] There might still be an expectation gap between the disclosed information and the requested information, but over the years UK company law has developed elaborate rules of disclosure requirements towards safeguarding shareholders’ interests.

One of the main instruments of disclosure is the directors’ obligation to produce timely and accurate annual accounts and reports. Under s 423 of CA 2006, companies are required to circulate copies of annual accounts and reports among their members. [53] Except for small companies, [54] the directors’ report shall also contain a business review so as to inform members of the company and help them assess how the directors have performed their duties. [55]

The disclosure process should be controlled to reduce the possibility of mistakes and fraud. Yet due to the limited time and knowledge on the side of individual shareholders, statutory auditing is required to facilitate efficient shareholder supervision and hence reduce the agency costs. To prevent future Enrons, UK law has deployed various strategies to ensure the independence of the auditors. A prominent one is to establish the audit committee by listed companies as recommended by the Combine Code. [56] Despite the ‘comply or explain’ approach taken by the Combined Code, the soft law has put shareholders ‘in a pivotal position in determining whether the Code’s requirements will bite in practice’ with the support from increasingly influential institutional shareholders. [57]

Conclusion

Bibliography

Cases