Duties of a Board

Introduction

The word ‘Board’ originally referred to the table around which a council sat. It was sometimes used in the 19th century to refer to a meeting of directors: when directors met they were said to ‘hold a board’-hence the term ‘Boardroom’ for a room in which the directors meet. Now ‘board’ has come to be used as a collective noun for directors [1] . The term ‘Corporate Governance’ derives from the Latin phrase, meaning “to steer”, which implies that corporate governance, involves the function of direction rather than control [2] . Apart from many other factors that influence on the systems of corporate governance, corporate ownership structure has been considered to have the strongest influence. Since the inception of joint stock companies there have been many transitional problems, which have been dealt with the adoption of new techniques and laws [3] . There are two main perceptions as regards to corporate governance. It can be used as a term defining the relationship between a company and its shareholders, on the other hand it can be seen as a web of relationships, not only between a company and its owners (shareholders) but also between a company and a broad range of other stakeholders: employees, customers, suppliers, auditors, regulators, financers, shareholders etc [4] . The second approach is now largely recognized as issues of accountability and corporate social responsibility are some of the principles on which the policy and practice is based in many countries. Corporate governance is the process of supervision and control intended to ensure that the company’s management acts in accordance with the interests of shareholder [5] .

The governance role is not concerned with the running of business of the company per se, but with giving overall direction to the enterprise, with overseeing and controlling the executive actions of management and with satisfying legitimate expectations of accountability and regulation by interests beyond the corporate boundaries [6] . The recent corporate debacles like Enron and others have raised serious issues of effective governance. In response to this in the United States there was the enactment of the Sarbanes-Oxley Act and in the United Kingdoms the Higgs Report and the Smith Report were published. Currently the boundaries of corporate governance have broadened to incorporate stakeholder concerns as well as shareholder accountability. The directors of a modern day company are to be concerned with far more than just running their companies to yield increasing shareholder value. Directors have far reaching responsibility to a wide ‘stakeholder’ group. This phenomenon can be seen in the present day aspects of corporate social responsibility and social accountability. With this background that corporate governance is the emerging, dynamic phenomenon that has undergone massive changes, this work is an attempt to analyze the matrix of duties and responsibilities of the board of a company, the growth and importance of boardroom responsibility and the role of non-statutory codes in bringing about effective corporate governance in the United Kingdom.

The Matrix

The concept of corporate governance and the relevance of the board’s responsibility have to be seen in correlation with the other wings of a company [7] . The other constituents to mention are the shareholders, the creditors, the employees etc. The matrix as stipulated in the diagram below is the responsibilities and duties of the different wings.

The unbroken lines, the arrows showing to whom these are owed, indicate explicit legal responsibilities. The broken lines indicate the responsibilities that are more implicit in their nature, and thus not generally to be identified as giving rise to legally enforceable obligations, in the absence of a specific agreement. The board is the focal point, owing in their corporate or even personally explicit legal responsibilities to all the others.

The concept of limited liability companies had a dramatic effect on the way companies were controlled and run. The idea behind this was that the owners of a company, the shareholders of listed companies, delegate the responsibility of managing the affairs of the company to a small group of individuals. This created a problem, which has been termed as the ‘agency problem’. The issue here is that the agents instead of making decisions in the best interest of the owner tend to pursue their own agenda. There seems to be a conflict in the goals of the principal and the agent [8] . The possible solution to this could be a better vigilance on the activities of the agents by the principal. This could be achieved in a number of ways. The possibility of having a nexus of optimal contracts between the principal and the agents, like remuneration contracts for management and debt contracts is a solution. The other practiced ways of monitoring the company’s affairs in the UK are in the course of shareholder, i.e., the principal exercising there power of voting in the affairs of the company [9] , for instance the composition of the board, remuneration of the directors etc., imposition of fiduciary duty on the directors by common law, a legal requirement of annual independent auditing, the vigilance of the FSA (Financial Service Authority), the Stock Exchange model code on directors’ share dealing, the Companies Act regulation on directors’ transactions and voluntary codes of governance. This is largely termed as ‘shareholder activism’ [10] . The main reason for the divergence in the initiations of the principal and the agents can be attributed to their different approaches to risk [11] . These methods of controlling the activities of the agents could be termed as market mechanism methods. These methods coupled with the ability of the shareholders to manage the affairs of the company must be effective to control the managerial behavior [12] . The fact that this not an effective method and the state of perfect competition being not possible in the markets, intervention in the form of policy documents and best practice codes of corporate governance is necessary. In the United Kingdoms there have been such policy documents in the form of codes from early 90s. Though these codes are voluntary. The companies listed on the stock exchange have to comply with the codes. The companies to build a better reputation for investment make it a prerogative to comply with codes [13] . The ones not complying will be branded as having weaknesses in the checks and balances of corporate governance. The whole set of responsibilities that the directors have so as to have the best form of corporate governance can be broadly termed as “boardroom responsibility”.

Codes of Practice

An insight into the failure of Enron would give a better understanding of importance of corporate governance and the policy codes. To put it in a nutshell the main reasons for the failure in Enron were, the flawed composition of the board of directors, the functioning of the non-executive directors, the non-performance of the internal audit committee, the company’s accounting and financial reporting flaws, the unchecked powers vested in the chief executive [14] . In response to this in the United States the Surbanes-Oxley Act was enacted. The main features are effective monitoring on three levels, internal, external and governmental. The internal control focus is on two critical actors the directors and the officers of the company, external control focus is on the ‘gatekeepers’, the lawyers and auditors monitoring the company and the governmental control is providing the state with powers of surveillance [15] . The Act provides for the creation of the Public Company Accounting Oversight Board, which prescribes the standards of auditing and accounting. In the UK there has been a move for reform since 1992.

The Cadbury Code 1992

In the UK one of the first initiations in relation to Corporate Governance was the Cadbury Report in 1992. This was the result of some scandals in the UK markets. The Maxwell affair that brought down the Maxwell Communication Corporation and the Mirror Group Newspapers along with many other companies. The flaw in the structure was that these companies lacked segregation of positions of power, the non-performance of the non-executive directors, the failure in the auditing section. The Cadbury report and the accompanying code were the findings of the Committee on the Financial Aspects of Corporate Governance [16] .

The Code covered three areas, the board of directors, the auditing and the shareholders. The Cadbury code suggested the monitoring and assessment of the board of directors as it formed the core of corporate governance mechanism. The issues of corporate transparency and communication with shareholders and other stakeholders were emphasized along with accounting and auditing functions. Finally the importance of institutional investors in the UK, this is considered to be the reason for the shift of directors’ dialogue towards greater accountability. This has brought the concept of corporate social responsibility. The Cadbury code is not a legal document but the Stock Exchange Yellow Book prescribed for a compliance statement by the companies. This is termed as the ‘comply or explain’ rule.

The Greenbury Report 1995

The Greenbury committee was constituted to address the shareholders concern over director’s remuneration. The committee consisted of leading investors and industrialist chaired by Sir Richard Greenbury. One significant aim was to create remuneration committees that would determine pay packages needed to attract, retain and motivate directors of the quality required. The aim was to increase accountability and to enhance performance. There was a requirement to have all the members of the remuneration to be listed each year in the committee’s report to the shareholders. The committees were to make a detailed report every year to the shareholders as regards to the pay of each of the directors.

The British Gas case was one of such instance wherein the votes of the institutional investors in their absence held in proxy by the majority were used against the minority votes that were against hefty remunerations declared to directors. Though this report dealt with the concept of remuneration of directors, an added view to this was again expressed in the Higg’s Report [17] .

The Hampel Report 1998

This report is rightly considered as the successor of both the Cadbury and Greenbury Committees. This report brought together all the issues considered under the Cadbury as well as Greenbury reports. The report propagated the need to maintain a principal based approach to corporate governance. Heavy regulations and checks could act as a deterrent on the growth of the companies and their progress. The report termed the approach as avoiding of the ‘box-ticking’ approach to corporate governance. The need for a general awareness of the importance of good governance and a principal based approach on behalf of the shareholders and stakeholders was emphasized.

There is a need for broad principles. All concerned should then apply these flexibly…to varying circumstances… the codes have been treated as sets of prescriptive rules. The shareholders or their advisors would be interested only in whether the letter of the rule had been complied with- yes or no. A ‘yes’ would receive a tick, hence the expression ‘box ticking’ [18] .

The report was seen largely seen as the one representing the interests of company directors. The report addressed the need for balance between the shareholders and stakeholders.

…We strongly endorse this accountability and we recognize the contribution made by the Cadbury and Greenbury committees. But the emphasis on accountability had tended to obscure a board’s first responsibility- to enhance the prosperity of the business [19] …

The other issues that were dealt in this report were role of directors, director’s remuneration, relations with shareholders and accounting and auditing.

The Turnbull Report 1999

In the aftermath of the combined code of 1998 the Turnbull code emphasized on the internal control in companies. It represented an attempt to have an explicit framework for internal control. A model of internal control was suggested and the companies were recommended to have an internal control mechanism based on that model. Given the problems of having different kinds of internal controls in the diverse sectors in which companies dealt, the model was not to be taken as prescriptive.

As we discussed above the approach towards risks in the market may vary from individual to individual. Individual companies have over a period of time evolved their own approaches to risk management and internal control. There was a view that the evolved systems were not effectively addressing proper internal controls. Standardization of internal control in all companies was an insurmountable task as companies’ risks varied so diversely. The Turnbull report provided for a basic framework of internal control [20] . The model framework involved different stages of internal control, the first being ‘identification and prioritization’ [21] . Then comes the ‘estimation’ stage, which involves the assessment of the potential impacts of identifiable sources of risk. The ‘developmental stage’ involves the company’s attempts to develop specific risk management strategy. Finally the implementation followed by evaluation of the strategy. There was also room for external feedback from the stakeholders in relation to risk management along with the need to take into consideration non-financial risks in their system of internal control.

The Higgs Report 2003

As in the United States, the fall of Enron has its effect in United Kingdoms as well. The need for re-evaluating certain corporate governance issues was felt in the UK. The role of the non-executive directors was the core of this re-evaluation. The combined code as prevalent in the UK was to be amended to meet the current demands. There was a suggestion of linkage of the role of the non-executive director and the role of the institutional investors. This was seen as the most effective method to counter the ‘agency problem’ as discussed above. The non-executive directors were to assume the mantle of the protector of the interests of the shareholders and the stakeholders.

The role of the non-executive director includes an important and inescapable relationship with shareholders [22] .

To assure the efficient discharge of this duty a number of reforms were called for like stipulation of the number of non-executive directors on the board, the remuneration to be paid to the non-executive directors, the independence of their working, training of the non-executive directors. The independence of non-executive directors was first raised by the Cadbury Report and re-emphasized by the Higgs Report. The definition of independence as per the Higgs report can be generalized from the following statement.

A non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the director’s judgment [23] .

The Smith Report 2003

The report was mainly intended to check the auditing standards in the aftermath of the Enron debacle. Effective auditing is one of the quintessential aspects of good corporate governance. The Cadbury report had stipulated the creation of an audit committee and had provided a view that the auditing is a means to check the activities of the directors. This report specifically dealt with the relationship of the external auditor and their relationship with the company. The role and the responsibility of the auditing committee were analyzed by the report. The role of the auditing committees as stipulated by the report were to review the companies’ internal audit function, monitor the integrity of the companies’ financial statement, make recommendations in relation to the appointment for the external auditor, etc. The most significant of all the stipulation was the independence of the auditing committee and the disclosure of the companies’ annual reports containing detailed information on the role of the auditing committee and the actions initiated by them [24] .

One of the most important features to be noticed in this report is the fact that again as its predecessors the Smith report too agreed that prescriptive approach would not serve the purpose. Instead a principle-based approach is the key to a growth of good governance culture.

Redraft of the Combined Code

The Financial Reporting Council approved a new draft of the Combined Code in July 2003. This code was rightly termed as, “the biggest shake-up of the boardroom culture in more than a decade” [25] . The code provided for a set of recommendation for good governance. Some of the salient points are:

• The separation of the post of the Chief executive and the Chairman;
• Number of non-executive directors on the board (at least half of the boards strength);
• Transparency in recruitment of directors;
• The presence of senior independent director to be available to the shareholders to deal with unresolved concerns;
• Tenure, qualification and terms of the non-executive directors;
• Importance of shareholder activism in the growth of corporate accountability and transparency and finally the executive remuneration

An analysis of the codes will reveal that in the UK the codes are prescribed best standard of practice and not binding rules. The codes too have always recognized that have a prescriptive approach is not an ideal mode. Instead a principle-based approach is the requirement. A straitjacket rule prescribing the best standard of practice is virtually impossible given the diverse nature of the market and different companies in them.

Boardroom responsibility can be the sum total of the adoption of the best standard practices as well the strict adherence of the legal duties as prescribed under the law. An attempt to have the codification of all the responsibility of the boardroom is impossible. We shall now for the better understanding of the boardroom responsibility consider the duties of the directors.

Director’s Duties

Boardroom responsibility is a wide concept that includes the duties of the board in efficient functioning of the company. Providing efficient governance is a part of the duty. Apart from the different kinds of duties of the directors, which shall be considered later, the duties of a director are analyzed here in reference to the entity or group to which these duties are owed to; the directors are responsible to the company, shareholders, creditors, employees etc.

The Company:

In Percival v Wright [26] it has been established that the directors owe their duties to the company and not to the individual members. This has been found to be too restrictive in approach since “the interests of a company, as an artificial person, cannot be distinguished from the interests of the persons who are interested in it.” [27] The obligation of the directors is that they owe a duty to the company. Since the company is constituted by the congregation of different wings as analyzed above (the matrix) all these duties owed to the company are in effect a channel serving a duty to other components of the company. “Directors indeed stand in a fiduciary relationship to the company as they are appointed to manage the affairs of the company, and they owe duties to the company.” [28] “The proper test of whether a director of a company has acted bona-fide in the interests of the company must be whether an intelligent and honest man in the position of a director of the company concerned, could, in the whole of the existing circumstances, have reasonably believed that the transactions were for the benefit of the company.” [29] A company has a dual aspect; it is an association of its members and is a person separate from its members. The director’s initiation exercised bona-fide in the interests of the company inevitably raises the question whether it is in the interest of the company as a separate entity or the interests of the members who constitute the company? The duty of a director is to promote the success of the company for the benefit of its members as a whole [30] .

The Shareholders:

The Companies Act provides that the directors are to consider interests of shareholders in discharging their duty to act in the interest of the company [31] . The first and foremost interest in the company is that of the shareholders and it is the interest and investment of the members that is to be safeguarded by the directors. However, Section 309 seems to be an ambiguous provision as it fails to suggest that the shareholders are to be given a priority over the people who have interests in the company. The enforcement of the interests of a company as a separate person and the interests of its members are distinct. The fiduciary duty to act in the interest of a company is owed to the company as a separate person. The members of a company have a statutory right to petition for relief of conduct of the company’s affairs in case of the conduct being unfairly prejudicial to their interest [32] . The unfair prejudice remedy makes it necessary to extend directors’ fiduciary duties to members [33] . ‘Shareholders’ can be both present and future shareholders which increases the ambit of directors duties, who have to act with such diligence as not to affect any interest of future share holders too in addition to looking after the interests of the present ones.

The Creditors:

The Directors have the objective of maximizing the profits of the shareholders. This view will have very little relevance in case of a company nearing insolvency or an insolvent company. Under such circumstances the interests of the creditors is to be guarded. In West Merica Safetywear Ltd v Dodd [34] , the Court of Appeal held that the directors of an insolvent company must have regard to the interests of the creditors. The creditors become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the assets of the company. “A company owes a duty to its creditors, present and future…the company owes a duty to keep its property inviolate and available for the repayment of its debts…” [35] The duty of the directors to act in the best interest of the company is not limited to the interests of the shareholders alone, the term interest here is to read to include the interests of the creditors as well [36] . The directors of a company, if deal with the property of the company in a way that is prejudicial to the interests of the creditors in case of insolvency of the company then they are in breach of their fiduciary duty to the company [37] . It is imperative for the directors, especially in the light of Section 213 and 214 of the Insolvency Act 1986 to ensure that they do not indulge in any fraudulent or wrongful trading while imparting their duties in the event of the insolvency of the company.

The Employees:

Section 309 of the Companies Act 1985 states the duties of directors towards the company and includes its employees and members [38] . Sub section (2) to Section 309 is very clear about how much the duty to the company by the director is owed and given the fact that in light of the case laws, it is imperative for directors to think in the interests of the company alone.

The Environment:

Capital markets are linked with the environmental policies as they provide the source from where the wholesale decisions are made regarding the future development and are therefore where pressures on the environment begin. At present, large institutional investors, notably the pension funds and life insurance corporations, dominate capital markets. [39] As regards strategic market significance, institutional investors could, through aptly targeted incentives and obligations, become more sensitive in their financial decision-making to environmental considerations. [40] In National Rivers Authority (Southern Region) v Alfred McAlpine Homes East Ltd [41] it was held that a company could be held liable for any acts of its employees that will result in endangering any of the environments or any acts, which add to any pollutant factors. As the board, which is in charge of the management of the company, will take most of the policy initiations it can be assumed that the directors have a duty toward the environment in taking policy initiations.

The stakeholder theory is currently accepted and the board is largely responsible not just to the shareholders but to stake holder at large and the directors in the wake of this approach have wide ranging duties. The case of Re Equitable Fire Insurance [42] , Romer J, reduced the duty that a director owed to the company in three propositions.

Requiring him to act with such care as is reasonable to be expected from him having regard to his knowledge and experience;

If he/she has any special qualifications, to use them for the betterment of the company;

To dispatch these duties with reasonable care.

FIDUCIARY DUTIES:

It is important that in general law, directors do not have individual powers but have to act collectively as a Board. [43] A ‘director’ is entrusted with the duties of the smooth running of a company in accordance with the powers conferred upon them by the Articles of Association and the members of a company. It becomes imperative upon them to fulfill their duty with utmost diligence. “Director, acting as a Board, has a duty to act in good faith in what they consider to be the best interest of the company.” [44] A fiduciary must act in good faith; he must not make profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal.” [45] The principles as set out in the case of Re Equitable Fire Insurance [46] set out the minimum standards of diligence and care that a director should keep in mind w