The UK Response to Corporate Governance

Divergence Of Interests

The objective of this paper is to explore the adequacy of the UK response to corporate governance by examining the relationship between the various factions within a company. Corporate governance essentially concerns the reconciliation of interests between the owners (shareholders) and the operators (management) of a company. By the dawn of the 20th Century, the board of directors were being perceived as an independent organ of the company rather than as mere agents of the shareholders who acted on their instructions. A further divergence of interests resulted from the increased trade of publically listed companies, resulting in further geographical spread of shareholders whose shares were likely to be smaller. This made the link between ownership and management more remote and harder to govern. Varying share sizes also meant that an inequality of voting rights between shareholders presented further problems, which are not present in company structures where the ownership and control are vested in the same people.

This separation of shareholders (owners), from the management (directors), resulted in what has been dubbed the ‘agency problem’. The directors of the company are managers of the shareholders’ capital, rather than their own; this therefore presents an obvious threat to shareholder’s interests, since directors may well act in their own interests and not that of the shareholders. Berle and Means observed that as the number of PLC’s grew and their shareholders became increasingly geographically, economically and characteristically diverse; the separation between ownership and management intensified and power shifted towards directors. This power was sometimes abused.

Part of the UK’s legislative response to this problem was through s172 of the Companies Act 2006, which obliges directors to hold shareholders’ interests as their primary objective. The UK has several mechanisms which attempt to reconcile these interests, which will now be considered.

Shareholder Democracy

The shareholders of a company are entitled to exercise certain powers in relation to the company, such as the approval of certain types of contracts between the company and its directors and the right to decide upon changes to the constitution of the company. Shareholders are therefore tasked with the role of reviewing the performance of the board, particularly when the annual report and accounts are presented to them and to take decisions if they think that performance has been inadequate. The Companies Act 2006, s.281 provides the only mechanism for shareholder decision-making for the adoption of resolutions by public companies.

Since Berle and Means’ analysis of patterns of share ownership, the general consensus indicates that shareholders are generally lax in using their rights which the law or the company’s articles confer on them to hold the management to account. Berle and Means noticed that shareholders were simply unmotivated to devote the time and effort required to seek change in management, as they only had small investments. Sealy explains that the annual general meetings of public companies are normally only attended by a small percentage of unrepresentative members:

“…the AGM no longer serves its original democratic function …the discussion is likely to be hijacked by ‘campaigners’ who have bought a few shares in order to gain publicity for their own separate agendas.”

Over 60% of investors on the London Stock Exchange are now ‘institutional investors’. The Combined Code expresses some faith in shareholder democracy: “Institutional shareholders have a responsibility to make considered use of their votes” and recommends that institutional investors should enter into a dialogue with companies. These provisions are hoped to increase institutional investors’ utilisation of ‘voice’ rather than ‘exit’. Traditionally they have preferred to utilise their right to exit the company rather than to voice any concerns about management, resulting in many instances where managerial decisions which were not in the interests of their investors have passed without resistance. One such recent example was the passive role of institutional investors during Sir Fred Goodwin’s acquisition of the ‘worst parts of ABN Ambro’. Lord Myners justifiably criticised RBS as an ‘ownerless corporation’. This example is merely one incident of many, which supports my contention that in practice we see an unbalanced distribution of power, culminating in favour of the board and not the shareholders, whose interests are granted priority.

The Combined Code

Since the Combined Code itself is a ‘soft law’, breaches of its provisions do not result in legal consequences. Yet, the Listing Rules require that companies have regard to the Code. The Listing Rules provide that companies must include in their annual report and accounts a statement as to how they apply the principles in the Code and whether they have complied with it during the year in question. Where a company has not complied with the Code, it must provide an explanation for the non-compliance.

This requirement ensures that the largest companies, those with the potential to damage the economy as profusely as Enron, are required to publicly explain any breaches. Therefore, whilst one may dismiss the code as ineffective due to its non-binding nature, I contend upon the arguments presented that the culmination of the Combined Code and the listing rules provide an effective system of checks and balances on the most powerful companies.

In Section 1, the Combined Code provides several important ‘main principles’ which affect the separation of ownership and control. It provides that every company should be headed by an effective, collectively responsible, board, who ‘should be supplied in a timely manner with information in a form and quality appropriate to enable it to discharge its duties’. It states that there should be a clear division at the head of the company between the running of the board and the running of the company’s business, and that no one individual should have unfettered powers of decision. Furthermore, it provides that there should be a formal and transparent procedure for the appointment of directors. It also provides best practice rules for remuneration, accountability and audit.

The soft law approach of the Combined Code means that action on reported non-compliance is left for shareholders to consider. This in turn results in a reliance on shareholders who, as discussed above, may have only limited interest in the management of the company. Thus, the long-term effectiveness of the Combined Code may rest on whether the attitudes of institutional investors can be changed in order to promote their active engagement with companies.

Davies has considered the effectiveness of the Combined Code and concluded that “there is evidence that there is some degree of non-compliance with even the ‘hard’ obligation of the L.R”. He observes that some companies have failed to explain non-compliance and that others give explanations which are inadequate, Davies also contends that “The level of enforcement by the FSA is relatively low”. However, Davies also concludes that companies generally choose to comply with the Combined Code rather than to explain non-compliance, and that where inadequate explanation is found, a company will normally remedy this by complying with the code rather than providing fuller explanation.

Non Executive Directors

Tiny Rowland once described the role of an NED as a ‘bauble on a Christmas tree…of no practical purpose except as a decoration to keep the institutional shareholders happy’. The role of NED’s has received mixed opinions. My assertion is that they play an integral role in corporate governance, having both strategic and monitoring functions whilst contributing expertise to inexperienced directors..

The Combined Code provides that the board of directors should include a balance of executive and non-executive directors, so that no individual can dominate the board’s decision making. It provides that, except for smaller companies, at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent. Additionally, a senior independent NED should be available to shareholders and in particular to act as an alternative contact with the chairman, chief executive or finance director where the normal channels have failed or are inappropriate.

Some commentators are in favour of the current position of non-executive directors, believing that they bring a different and objective perspective to the board of directors. NEDs may improve the internal management and performance of companies, and provide a check on the power of the executive directors.

Yet others perceive problems with the role of NEDs. Sweeney-Baird has noted that the function of the NED “creates an essential conflict” in that if they are only part time then they do not have time to perform all the necessary tasks, and yet if they are full time they may not be independent.

Kiarie further doubts the true independence of ‘independent’ NED’s particularly because of their appointment through relationships with executives. She notes that NED’s rely on the executives to provide information to them, and that these executives are in a position to edit, delay or incompletely disclose information to NED’s. Kiarie even goes so far as to say that “the Code provisions are toothless since, although they require the provision of information, there is no mechanism to enforce this. Where executives decide to withhold information from the NEDs, they have no legal remedy.

Furthermore, although the subjection of NEDs to the same level of directors’ liability as executives may appear to benefit the standard of corporate governance by ensuring that NEDs fulfil their role, the down side to this situation is that it may act as “a disincentive for those willing and able to act as NEDs in a market where the same are already in limited supply.” Ultimately, the NEDs are not directly accountable to the shareholders, and there is no mode of redress for NEDs who are displeased with executive performance. I feel problems are likely to weaken the potential benefit of non-executive directors, who could otherwise be an important and powerful mechanism for ensuring the correct balance in the separation of ownership and control.

Conclusion

In conclusion, the separation of ownership and control in listed PLCs has the potential to create problems as shareholders tend to be diverse and uninterested in the day-to-day management of the company. This opens the door for abuse by those in control of the company, the board of directors, who may seek to act in their own interests, rather than in the interests of the shareholder owners. The UK has utilised several mechanisms in order to attempt to combat this problem. This paper has discussed three such mechanisms in detail: each of these mechanisms offers a check on the power of the executives. However, none of these mechanisms, individually, may be said to be completely effective.

The weaknesses of each are significant and have been discussed above. The lack of effectiveness may lead to the unfortunate consequence of continuing corporate failures and abuses of power. Yet, it is hoped that cumulatively, the mechanisms for the monitoring of separation of ownership from control will operate more successfully than they could do in isolation. The combination may well have the effect of changing the attitudes of both shareholders and the board, ultimately making the controllers of the company more accountable.

However, the ownership of corporations is currently so diffuse, international and spread among investors with often conflicting investment aims that it is not obvious how to rectify the problem. A major limitation is that shareholder’ stakes in individual companies are small in voting right terms; the cost and trouble involved in monitoring do not outweigh the ease of simply selling one’s share. Although this presents difficulties in monitoring management; the Combined Code system and the public pressure on companies to conform to the Code are both attributable to the influence of institutional shareholders across the whole market. Maybe the logic is that it easier to monitor compliance with the Code than it is monitor management. Whatever the best approach, the need for effective corporate governance has never been higher given the recent banking crisis and tax-holder stakes in banks, as highlighted by the recent Walker report.

Bibliography

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S,Kiarie, “At crossroads: shareholder value, stakeholder value and enlightened shareholder value: which road should the United Kingdom take?” (2006) ICCLR 329, 336

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S.Kiarie, “Non-executive Directors in UK listed Companies: Are they effective?” ICCLR (2007) 18(1), 17-23 accessed 5 January2010.

Legislation

Companies Act 2006

UK Combined Code on Corporate Governance