Discuss the relationship that exists in the UK between the legal rules that govern directors' duties and principles of corporate governance.

Company Law Coursework.

“Companies whose standards of corporate governance are high are the more likely to gain the confidence of investors and support for the development of their businesses”.

(Report of the committee on the Financial Aspects of Corporate Governance – Cadbury Committee Report (Para 1.6)

In the light of this statement discuss the relationship that exists in the UK between the legal rules that govern directors’ duties and principles of corporate governance.

Corporate governance is a very wide topic area it does not have one set definition its literal meaning is that of united group control however it’s a much wider subject area. Corporate governance covers a wide range of issues from the role of the company secretary and legal department, to the business strategy, the roles of the executive and non-executive directors, the relationship between investors and companies and accounting and information systems. A corporate governance structure should set guidelines as to how responsibilities are distributed throughout the company it should also give guidelines on the decision making process. It should structure the way in which objectives are met and monitor the progress in meeting such objectives.

Companies need to maintain a good corporate governance structure to ensure that they are efficiently run. Good governance could be seen more as a mentality than an actual set process it is more to do with how the company portrays itself to the public, the investors and to its staff. It is needed in all sizes of organisations.

“Good corporate governance is running the company on behalf of the shareholders and other stakeholders.” – Chris Jackson (2003),’Foreword’, Management Quarterly, Corporate Governance issue 21 (October) p.3.

Corporate Governance relates strongly to directors duties which in the UK are partly regulated by legislation in The Companies Act 1985 and to from precedents set in common law these duties are split into three areas, fiduciary duties to shareholders, duties of skill and care and finally conflict of interest. As well as being regulated by statute and common law they are governed by the principles of corporate governance which are laid down in The Combined Code. Technically these principles are more conventions than they are legalities so do not need to be directly adhered to, however The Stock Exchange does require that companies adhere to The Combined Code and also that they state in their annual reports that they have adhered to it as well as stating what they have chosen not to follow and to give a reason for not doing. It’s obvious that to ensure that a company is run well it needs to be well structured and part of structuring a company is how it is governed; this in turn makes good governance a necessity for the success of a company. Good governance can be classed as many things from form filling to conforming to shareholder needs and following The Combined Code but in short it is the running of a company ‘properley’ making sure that business is met not just equitably but also ethically. Even in cases where it is not required by law or preferred by The Stock Exchange it is needed to ensure the confidence of stakeholders and shareholders. Good governance is crucial for a company to succeed in the future.

The need for corporate governance is highlighted by the corporate failures seen in the 1970s 1980s and 1990s such as Leeson bringing down Barings bank, Maxwell helping himself to the pension funds, the collapse of Polly Peck and Tiny Rowland running Lonrho as though it was his own. Examples can also be seen across the water in the US with the collapse of Enron. All these cases helped bring focus on the topic of corporate governance the result of this focus was The Cadbury Report which included the code of best practice. This code set out guidelines for the board of directors, non-executive directors and executive directors to follow as well as giving guidelines on reporting and controls. It became a requirement from the 30 June 1993 that all listed companies stated their compliance with this code in their company reports and where there was no compliance they had to state why.

This is a preview of the whole essay

The Cadbury Report combined with Hampel and Greenbury led to the publication of The Combined Code which set principles of good governance and details of relevant disclosures. The Combined Code was published in 1998 by the Hampel Committee, the code covers a range of best practice issues including issues such as the length of directors contracts, reporting and voting on remuneration and the independence of remuneration committees, the roles of chairmen and chief executives, the proportion of non executives and many other matters. The Combined Code is compulsory for all UK listed companies however compliance with the principles is not mandatory but non compliance must be stated and explained in the reports. This was stated in rule 12.43A of the current listing rules the comply or non compliance explanation gives companies the freedom to explain their individual policies on governance, shareholders should not be alarmed if a company chooses not to comply to certain guidelines set by the combined code as it may just mean that the company has a different way of dealing with the matter, shareholders and stakeholders have the right to question any explanations of non compliance if they don’t sound convincing. A revised combined code was issued in January 2003 which replaced the old Combined Code which came into use on 1 November 2003. The code does not over ride any legislation or general requirements especially including those relating to treating shareholders equally in regards to accessing information.

The Combined Code can be separated into four sections; directors, directors remuneration, relationship with shareholders and accounts and auditing. In this question I am focussing primarily on the section relating to directors and looking how the principles of the combined code relate to legal rules in governing directors duties. Section 1A of The Combined Code relates to company directors in this section there are 7 main principles, the first of which states;

“Every company should be headed by an effective board, which is collectively responsible for the success of a company.” The Combined Code 2003 S1A.1

This can also be reflected in the articles of association which contain rules governing the powers of internal constitution of a company such as appointing directors, the powers of the board, the rights of the different shareholder classes and the structure of company and general meetings. The articles of association are one of the required documents for registering a company they are found in The Companies Act 1985 s.7. Under s.8 of the same act it is possible to find Table A which prescribes regulations by the secretary of state, it is possible for companies to just set the regulations of table A as their articles. There is an also an overlap of this principle in the code of best practice so this can be seen as a fundamental issue in the running of a business. The next principle covers the area of chairman and chief executive;

“There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the companies business. No one individual should have unfettered powers of decision.” The Combined Code 2003 S1A.2

Although it is possible for the chief executive to also hold the positions of managing director or chairman this principle is saying it is not the best idea for the company to have such a high concentration of power, it creates a huge control issue. The Companies Act 1985 S8 Table A gives the power to appoint a chair however it doesn’t give restrictions on who should be considered for such a position. A clear division in the responsibilities will ensure a balance of power and authority. A Chairman is responsible for the running of the board of directors whereas a Chief Executive is responsible for the running of the companies business, Chief Executive is not a legal term it is something created by the business. This can also be seen to have a relation with the part 3 of S1A;

“The board should include a balance of executive and non executive directors (and in particular independent non executive directors) such that no individual or small group of individuals can dominate the board’s decision taking.” The Combined Code 2003 S1A.3

This principle is suggesting that the board should be of a sufficient size and should hold enough skills and experience to benefit the company; it should also not cause disruption to the running of the company if there are changes to the make-up of the board. This may be seen as common sense but if the board is of sufficient size then it prevents small allegiances from having a concentrated amount of power or knowledge of the company, it also makes decision making a fair process. Again executive and non-executive are not legal terms, in the eye of the law all directors are equal and are treated as equals. The fourth principle on directors is regarding appointments to the board;

“There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.” The Combined Code 2003 S1A.4

The appointment of a director is surrounded by regulation and enforcement. Companies House must have the details of companies’ directors on the register. There are also the provisions set in Table A: Article 64 stating that there must be 2 or more directors, Table A: Article 78 which states that a director is to be appointed by the general meeting not by another director or by the board. Table A: Article 79 requests that there is a co-option between general meetings. The Combined Code suggests that the appointment of new directors should be by a nomination committee with the majority of the committee being made up of non-executive directors, it also suggests that there should be a balance on the board of executive and non-executive directors. The appointment of directors also brings up a conflict in the law; employment law suggests that the managing director should appoint new directors whereas company law suggests that appointment should be by the general meeting. Other legal rules on this point are stated in The Companies Act 1985; S292 says that they are not to have been “disqualified” it also states that anyone over the age of 70 cant be appointed to the board of a plc. This also relates in part to The Combined Code 2003 S1A.7:

“All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board.” This again can be compared to The companies Act 1985 Table A: Articles 78 & 79 which are basically saying that if a director is appointed by the board between the AGMs then at the next AGM they will loose the post and the shareholders will be given the option to re-elect. The Combined Code suggests a re-election period of every 3 years. This is to keep the management fresh as well as to allow the shareholders to have their opinion on a director who they do not think is acting in the best interests of a company. Going back to the fifth principle of the code;

“The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.” The Combined Code 2003 S1A.5

The management of a company is obliged by law to provide information to the board and to shareholders however it is up to directors themselves to seek clarification on any matters. The final principle of The Combined Code relating to directors duties is on the subject of performance evaluation:

“The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.” The Combined Code 2003 S1A.6

It also states that the way in which director’s performance is evaluated should be commented on in the company reports. Appraisals or evaluations can prove very valuable to a company they highlight areas which weaken staff morale as well as showing which staff may be ready to retire giving the company time to find a reasonable candidate to take over the job. There is no legislation surrounding performance evaluation however a good system makes for good governance which helps instate investor faith. All these principles come together to form a frame work which sets and example for the ways in which directors should carry out their duties, this frame work helps to gain investor confidence as it shows investors that the company is acting legitimately and in their interest. Technically law says that the company is its own entity, the company owns itself however there is also this idea that shareholders provide the funding of a company and are the principals, so they are the owners however in theory the shareholders can not direct the board how to act they can just vote yes or no. On the other hand the board of directors who are seen as the agents of the company should work in the best interests of the company and not the shareholders. The idea of governance is to maintain a certain level of control of a company and to run it “properly”. Many of the principles in The Combined Code look at shareholder interests. The shareholders must be given sufficient information, the share holders must re-elect, The Combined Code looks out for shareholder interests as well as the company’s interest it makes sure that directors are not taking unfair advantage of their position in the company.

The Combined Code also goes on to look at director remuneration, the level and make up of remuneration saying that it should be sufficient to attract and maintain but not more than necessary and that a portion should be linked to performance. This prevents directors from giving themselves ‘fat cat’ salaries and taking money out of shareholder dividends to fund such salaries. It also focuses on the procedure of director’s remuneration and states that it should be formal and transparent for developing policy and fixing remuneration of individuals, it can be seen how much directors earn in the annual report of a company and now a days many people look at that first when looking at investing in a company. The Combined Code also states that there should be disclosure of directors remuneration, including the policy and details of remuneration for each director this gives the shareholders an insight of how and why they earn what they do giving shareholders reasonable grounds to question what they don’t agree with and reject any salaries which they think are too large. It also has a section on the relationship with shareholders, this says that the directors should be ready to enter into dialogue with institutional shareholders and also that there should be constructive use of the AGM, it should be used to communicate with private investors and to encourage their participation in AGMs rather than letting directors and institutional shareholders take the lead. The final section in The Combined Code is surrounding the accounts and auditing it looks at financial reporting and says that an annual report should be issued and should present a balanced and understandable assessment of the position and prospects of the company in the years to come. It also focuses on internal control and emphasises that a sound system of internal control can be maintained. The final area highlighted in the accounting and auditing section is looking at the audit committee and the auditors it again says that the arrangements should be formal and transparent for considering how to apply financial reporting and internal control principles and to also maintain a healthy relationship with the auditors. This should prevent any information asymmetry between principals and agents as was seen in the case of Enron.

The UK's approach to governance is a self regulatory approach unlike the US legislative approach. Brussels have looked into creating a European corporate governance code however they came to the conclusion it was not necessary and agreed that the European Union should create a common approach which would coordinate national corporate governance codes. If legislation is brought in it would defeat the point of corporate governance as it would cause restrictions on a company rather than the flexibility provided by The Combined Code.

It is said that companies who follow a code of corporate governance have a more stable price/earnings ratio this is due to the management of their financial assets, the code helps them manage their assets more efficiently and so they are seen as more stable companies in which to invest. This in turn creates a confidence in investors who are willing to support the development of their company as they have faith in their investment due to the guidelines the company follows set by The Combined Code.