Paper Explaining Corporate Governance

Corporate Governance

The Concept of Corporate Governance

Corporate governance is the system by which companies are directed and controlled. The term refers to the processes of supervision and control intended to ensure that the company’s management acts in accordance with the interest of the shareholders. Corporate governance strives to provide a balance between the freedom of management to make commercial decisions and control over management. Essentially, it deals with the relationship between the two controlling organs of the company; that is, ownership personified by shareholders and management personified by directors.

Two essential features that underline the U.K. corporate governance system already emerge from this brief exposition; firstly, the concept of corporate governance in the U.K. is founded on a system of accountability directed towards maximising profits for the shareholders. Note that the traditional notion of profit maximisation for shareholder (or the shareholder primacy position) is still entrenched in and indeed still defines not only British corporate governance but also British company law as a whole. Company law perceives the company as belonging to the shareholders for the sole objective of maximising profits and is thus, designed to achieve this outcome. Every other interest is secondary. The second feature that emerges from the above exposition is the apparent conflict of control between ownership, personified by the shareholders and management, personified by the board of directors. The conflict results from management’s desire to make commercial decisions in the interest of the company as a whole as seen earlier and the shareholders’ desire to control management.
We will now examine the structure of corporate governance to determine how power is shared between shareholders and directors, because that is what corporate governance is fundamentally about.

The Corporate Governance Structure

As mentioned earlier, corporate governance essentially deals with the balance of power between shareholders and directors. In this part of the discussion, we will see how power is shared between these two governing organs. But there is also a third organ in U.K. company law, thus leading to a tripartite system of corporate governance, i.e. the auditors. In this tripartite system, directors are regarded as leaders of the company’s management, charged with maximising the company’s profits, while the role of shareholders is to ensure inter alia that directors will maximise profits on their behalf. The role of the company’s auditors is to ensure that there are no financial irregularities in the company and that the directors provide a true and fair view of the company’s financial performance. In principle, auditors are formally appointed by shareholders and their primary responsibilities are to the shareholders. However, in practice the audit firm is selected by the board. This tripartite system operates as a means of checks and balances to ensure that directors do not abuse their powers within the company. So, how does this tripartite system operate? We now look at the substantive law. First of all, it should be mentioned that the corporate governance structure is set up by company law and the memorandum and articles of association of the company.

I have represented the governance structure on the following diagram which I hope will facilitate our understanding of some of the apparently complex aspects of the corporate governance mechanism.

The Corporate Governance Structure

Shareholders (General meeting)
-Appoint the board at general meetings. Primarily concerned with monitoring directors.

Board of Directors (Appointed at General meeting)
-Manages the company and makes business policy decisions. -Consists of the Executive board (appointed by the shareholders) and the Supervisory board (appointed by other stakeholders including employees, creditors, etc.)

Executive Directors, i.e. MDs or Chief Executives
(Appointed by board)
-Carry out executive functions of the company under contracts of employment. -Day-to-day management of the company.

Shareholders (General Meeting)

As mentioned earlier, the corporate governance structure is set up by company law and the company’s constitution. The company must hold an Annual General Meeting unless it has opted out under section 116 of the Companies Act 1989. Section 116 of the 1989 Act allows members of a private company to elect by resolution in general meeting to dispense with certain of the requirements of company law. The AGM must be held in addition to any other meeting that are convened. AGMs must not hold more than 15 months apart. By virtue of their proprietary status, shareholders appoint and dismiss directors by ordinary resolutions passed at the general meeting in accordance with the company’s memorandum and article of association. This power is given statutory recognition under section 303 of the C.A. 1985. Shareholders, at the general meeting, also have the power to alter the company’s constitution, the right to authorise an increase in its capital and the issue of new shares, the right to sanction the payment of dividends. In addition, shareholders also have a role in confirming transactions in which the company has a conflicting interest.

The Relationship between the General Meeting and the Board

A much-debated (vexed) question is whether the shareholders have any powers in general meetings to direct the directors in the management of the company. The powers of the shareholders in general meetings to direct the directors in the management of the company depends on the construction of the articles of association vesting powers of management in the directors. It has long been established in a long line of cases that it is perfectly acceptable for the board to have powers quite free from interference by shareholders. The importance of the articles of association has been confirmed by case law in Automatic Self-Cleansing Filter Syndicate Co v Cunninghame [1906] 2 Ch. 34, where the Court of Appeal made it clear that the division of powers between the board and the company in general meeting depended in the case of registered companies entirely on the construction of the articles of association and that where powers had been vested in the board, the general meeting could not interfere with their exercise. In Scott v Scott [1943] 1 All ER 582, ChD, a company's shareholders passed a resolution at a general meeting that certain payments in respect of dividends should be made to preference shareholders. It was held that the resolution was invalid as an attempt by the shareholders to usurp the directors' powers of control.

The position adopted by the courts in these two cases has been given statutory recognition. Under Article 70 of Table A of the Companies Act 1985 the general meeting can interfere only by ‘any directions given by special resolution’. Article 70 provides; "The business of the company shall be managed by the directors, who may exercise all such powers of the company."

Thus, case-law and statute recognise that management of the company is usually delegated by the shareholders to the board. Subject to the provisions of the articles, the company in general meeting may not, therefore, override the directors' discretion or direct the board on how to act. Thus, if shareholders do not approve of the directors' acts they must either remove them under s. 303 or alter the articles to regulate their future conduct. They cannot simply take over the functions of directors. The inability of shareholders to control the company contrary to the articles is further demonstrated by Quin & Axtens Ltd v Salmon [1909] AC 442, where article 75 of the company’s articles provided that the business of the company shall be managed by the directors (i.e. Salmon and Axtens) who might exercise all the powers of the company ‘subject to such regulation as may be prescribed by the company in general meeting.’ Article 80 stated that no resolution of a meeting of directors having for its objective, the acquisition or letting of certain premises should be valid if either Salmon or Axtens dissented. The directors resolved to acquire and to let certain property but Salmon dissented. The directors then called an extraordinary general meeting at which the shareholders by a majority the decision. Salmon sued for an injunction to restrain the company and the other directors from acting on the decision. HL held the shareholders resolutions were inconsistent with the articles and granted an injunction restraining the company from acting on them. The court found that the company was trying to bypass rules on decision making contained in the constitution without following the procedure for altering the constitution.

A related question is what is the position where company has no directors or where the directors are unable or unwilling to act. A general meeting, however, may be able to act where the company has no directors, as in Alexander Ward & Co Ltd v Samyang Navigation Co Ltd [1975] S.C or where the directors are unable or unwilling to act, as in Barron v Potter [1914] 1 Ch 895. In the Alexander case, a company which had no directors commenced an action to arrest a ship. The defendants claimed that as there were no director, the company could not authorise the action. It was held by the HL that the company in general meeting could ratify the commencement of the action. In the Barron case, it was held that appointments of directors made at an extra-ordinary general meeting were valid (Thomas, C.D., Company Law for Accountants, 2nd, ed. 202).

Thus, although the general meeting cannot generally direct directors in the management of the company, it is still the primary organ of control in the company as seen earlier. It was seen that they have the powers to alter the company’s constitution, to appoint and dismiss directors, the right to sanction the payment of dividends, etc. The importance of the general meeting lies in the fact that company law reserves certain decisions in the running of the company to be taken by shareholders in general meetings. In addition, general meetings also provide an opportunity for shareholders to call into account the board of directors and to ask questions about the board’s performance and future plans. In this respect, general meetings can be seen as one of the mechanisms company law provides for ensuring the accountability of the board to shareholders.

Despite this, however, in large public companies, general meetings play a relatively insignificant part in securing the accountability of management. This is largely due to shareholder apathy in the management of the company as manifested by their non-attendance at general meetings. Shareholders do not attend general meetings for a number of reasons including the fact that they are widely dispersed across the world.

The Board of Directors (Management)

The board of directors is appointed at the general meeting by the shareholders. Section 282 of the C.A. 1985 provides that every company must have at least one director. The first directors named in any company are the directors named in a statement by all the subscribers and delivered with the memorandum and articles of association of the company to the registrar when the company is formed. Although the C.A. 1985 requires that every company must have a director or directors, and although it attributes many functions to and obligations on directors, it does not itself prescribe how the business of the company is to be managed. This and some other aspects of the law relating to directors and other officers are left to the articles. The article will determine the power of the board vis-à-vis the shareholders in the general meeting, and the ability of directors to delegate their powers.

The board is responsible for the day-to-day management of the company. Company officials are answerable to the board, but the board is only answerable to the company as a whole not the shareholders. In practice, however, much authority is delegated to a managing director and other executives. The managing director has the apparent authority as an agent of the company to enter into business contracts with third parties. His actual authority derives from the articles which usually stipulate that the directors may confer on a managing director 'the powers exercisable by them upon such terms and conditions and with such restrictions as they may think fit.'

Executive Directors

An important feature of the board structure is the distinction between Executive Directors and Non-Executive Directors. An ED is usually a full time director of the company appointed to perform specific tasks. Table A, article 84 of the C.A. 1985 empowers the board to appoint one or more of their number to any executive office under the company. An executive director may be a managing director, or the chief executive or any senior officer of the company. In practice, they are in charge of the day-to-day management of the company.

Non-Executive Directors

The post of NED is one which does not carry managerial responsibilities. Persons appointed to hold office as NED are quite often chosen because of an expertise or public recognition in some particular area. As shown on the diagram, NEDs are in general not involved in the day-to-day management of the company. An obvious advantage of this is their ability to assess the company’s performance and that of management from a more neutral standpoint. They are now common in large companies.

Corporate Governance Reform

In this section, we will look briefly at the attempts that have been made to reform corporate governance in Britain. We will start with the Cadbury Committee Report.

The Cadbury Committee

The Cadbury Committee was established in May 1991 by the Financial Reporting Council, the London Stock Exchange and the accountancy profession, in the wake of financial scandals in big companies such as BCCI, Maxwell, etc, to review the financial aspects of corporate governance. The Committee published its final report in December 1992. Although its objective was not to review corporate governance itself but merely its financial aspects, it nevertheless made many important proposals to corporate governance. Some of which are;
- The Committee was particularly concerned with the constitution of the board and recommended that it should be split between Executive Directors and Non-Executive Directors, with the latter comprising about one third of the membership. It felt that there should be a well-defined split of responsibilities at the helm of the company to ensure a balance of power and authority. NEDs give the constraints under which the board operates and take a less active part in the life of the company.
- The committee recommended that appointment of NEDs should be by the board and not by senior management. It felt that the NEDs should further be independent so that they may not have any business with the company (an issue re Paulson and Goldman Sachs?).
- Perhaps most significantly, the Committee maintained the unitary (one-tier) board system.
- The Committee also made numerous proposals relating to the relationship between shareholders and directors, the overall objective of which was to improve accountability. It emphasised in paragraph 6.5, the need for the board to become accountable to shareholders.
- It attempted to bring individual directors under the scrutiny of the board.

Cadbury’s key proposal was for companies to adopt a committee system as a means of improving the effectiveness of the board structure and enhancing the strength and influence of non-executive directors. It was recommended that each company should have at least three committees dominated by non-executive directors. The establishment of these committees within the key functional areas of the corporate structure was designed to increase significantly the power of NEDs in those areas which had previously been causes of contention between directors and their shareholders. Cadbury believed that an effective system of corporate governance can be achieved by striking a balance between allowing directors freedom of action to further the commercial interest of their companies on the one hand, and instituting a framework of effective accountability on the other. It believed that this balance can be achieved through a system of voluntary self-regulatory codes. Thus, the committee drafted a Code of Best Practice which listed companies were to adopt voluntarily.

It is obvious that in terms of the relationship between shareholders and directors, the Cadbury Committee sought to give shareholders a greater say in corporate governance while simultaneously curbing the powers of individual directors and allocating them to the board of directors in order to safeguard against abuse of excessive power. The Committee proposals did not escape criticisms but time does not permit us to look at these criticisms.

The Hampel Committee
Another attempt at reforming corporate governance is the Hampel Committee which was set up in November 1995 with the following objectives;
- to review the Cadbury Code and its implementation,
- to review the role of directors,
- to address the role of shareholders and auditors in corporate governance issues,
- and to deal with other relevant matters.
In its preliminary report published in August 1997, the Committee;
- rejected the principle of stakeholder democracy and a two-tier board system,
- rejected the government’s idea for a standing panel on governance,
- asserted that companies are more concerned with accountability than with business prosperity,
- stated that companies should include a statement in the annual report on compliance with broad corporate governance principles.

The Company Law Review Steering Group

In March 1998, the Secretary of State for Trade and Industry launched a consultation paper on Company Law Reform. The aim of the Consultation paper, entitled ‘Modern Company Law for a Competitive Economy’ was to carry out a fundamental review of the framework of core company law including how it can be modernised. A Steering Group was appointed to manage the review. The Group has published four elaborate consultation documents detailing the nature of the problems it addressed, the scope, the process, responses from companies and other parties consulted and finally proposals for reform. Corporate governance is an important feature in the consultation documents, in particular, the one entitled Modern Company Law for a Competitive Economy: Developing the Framework, published by the Department of Trade and Industry, Company Law Review Steering Group in November 2000. The Group found inter alia, that there were concerns about the genuineness of the independence of NEDs and their real ability to hold management to account. The Group reviewed and made proposals on different aspects of corporate governance such as; directors’ duties, the relationship between shareholders and management, reporting, accounting and audit. Most of the respondents in the consultation exercise, favoured the status quo and so no need for changed.

In the first two publications entitled The Strategic Framework, published in February 1999, and Developing the Framework, published in March 2000, the Group favoured the current law on directors’ duties which requires directors to manage the company solely for the benefit of shareholders. The Group rejected what it called the ‘pluralist approach’, which would allow directors to run the company for other purposes where the direct economic interests of those with business relationships with the company (such as the needs of employees, or suppliers, or the local community or the wider public), demanded it. It favoured what it called the ‘enlightened shareholder value approach’. Under the enlightened shareholder approach, the company would be run in the interest of the shareholders by taking into account other groups that have an economic relationship with the company, e.g. employees, customer, the local community, etc.