A Critical Examination of the Impact of Section 172 of the Companies Act 2006

There has been a plethora of debate surrounding the approach to directorial decision making in the scheme of corporate governance. A divergence has emerged between numerous schools of thought as to whose interests the directors are to consider in conducting the company’s management. The approach under English law is codified under section 172 Companies Act 2006 (‘CA 2006’) which professes an ‘enlightened shareholder value’ approach to corporate governance. This has given rise to scrutiny and challenge from numerous critics but most notably from proponents of the ‘stakeholder management’ stance. The aim here is therefore to evaluate the scope and impact of section 172 and consider the possible alternatives whilst seeking to establish whether section 172 can be considered a positive development within company law.

1. Previous approach

Under the common law, directors were required to act in good faith in what they believed to be in the company’s best interests. The main problem was that the company is a legal abstraction and acting in the ‘company’s interests’ is a fairly obscure and elusive concept; thus reform was necessary so that directors could ascertain what the ‘company’s interests’ actually entails i.e. whose interests it is referring to[1]. Moreover, under section 309 Companies Act 1985, directors were to have regard to the ‘interests of the company's employees in general, as well as the interests of its members.’ This suggested that members and employees could feature in decision making but there was no stipulation as to whose interests were predominant and directorial discretion was arguably too wide. The provision was also quite otiose given that employees had no right of enforcement and reform was needed to restore some clarity.[2]

2. Section 172 CA 2006

Section 172 inaugurated an ‘enlightened shareholder value’ (ESV) approach so that directors, in fulfilling their duty towards the company’[3] are required to ‘act in the way [they] consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard’ to other factors insofar as they promote the company’s interests; thus, the legislation equates the interests of the shareholders with the company’s success. Although other factors such as, inter alia, the company’s employees[4], suppliers and customers[5], the long term consequences[6] etc. are to feature in decision making, these factors will be subordinate to the interests of the shareholders. Thus, the intention of the provision is not to engender a surreptitious adoption of ‘stakeholder management’, as the assertion suggests, since the interests of other stakeholders are only instrumental to ensuring that the company is profitable which is causatively linked to the members’ interests.

The imposition of a subjective standard by requiring ‘good faith’ appears prima facie to be counterproductive to consistency as it does not appear to set any threshold standard for directors. Nonetheless, the Guidance illustrates that compliance with section 172 is supplemented by the ‘duty of care’ embodied under section 174 thus providing some form of objectivity given that directors are required to act with a degree of ‘reasonable care, skill and diligence’.[7] In Regentcrest v. Cohen,[8] Parker J articulated that a subjective standard necessitates a consideration of what the director ‘genuinely’ and ‘honestly’ believed was conducive to promoting the company’s success. This, in conjunction with ‘good commercial reasons’[9] for acting entitled the High Court to conclude that a policy to excuse the debts of the directors was advancing the success of the company since it was valuable for the company to retain their directorial services. Although this decision was reached in a climate where ‘proper purpose’ and ‘bona fide’ were amalgamated, it is submitted that even now a similar approach would be taken, as directors are required to act in accordance with section 174. The courts seem reluctant to interfere with directorial decisions on the premise that corporate entities should be largely administered by internal management save to the extent that legal input is unavoidable. Directors are in a better position to meet the demands of the individual company[10] and the courts thus adopt a non-interventionist stance. Therefore, the subjective standard is a positive development in the law since it appreciates the need for decision making to be resolved internally.

The CA 2006 has been criticised for reserving the notion of ‘success’ to the directors’ individual judgment. The view that a company is ‘organised and carried on primarily for the profit of the [shareholders]’ has been articulated in the US decision of Dodge v. Ford Motor Co.[11] Faure has said that this also reflects the English approach.[12] This appears correct since commercial advancement is a central company objective and the case law demonstrates that extraneous considerations like climate change should not be furthered to the detriment of the value of shares.[13] Nonetheless charitable companies[14], for instance, are not commercially motivated and so success is largely measured by ‘value’ but not always.

In the context of directors contracting so as to fetter their future discretion, there has been some ambivalence as to whether such contracting is conducive to company’s success. The conventional stance indicated that fulfilling a contractual undertaking with a third party would inevitably generate inconsistency with the company’s interests.[15] Nonetheless, this has subsequently been qualified and in Fulham FC v Cabra Estates,[16] Neill LJ accepted that contractual arrangements conferring substantial benefits on the company should not be prohibited. The rationale here is arguably that the legislature could not have realistically intended a blanket ban on such contracting at the expense of the company’s commercial success since it would undermine the underlying policy behind the provision. Thus, section 172 can arguably be viewed as an effective development in ensuring that the company’s success is always at the forefront of decision making.

It can be inferred from Keay’s assessment of section 172 that the provision may suffer from the problem of enforcement, thereby repeating the deficiencies of section 309.[17] Generally, claims will only be brought by virtue of a derivative claim by shareholders[18], liquidators upon insolvency[19] or by a new Board upon transfer[20]. Thus, the view that the provision will engender ‘stakeholder management’ is misguided because other stakeholders have no means of enforcing the provision. Moreover, given the litigation costs and the difficulties in surpassing the derivative claim preconditions, it will be difficult to mount a successful claim against a defaulting director. Furthermore, there is a concern that the ‘have regard to’ list will make it more difficult to challenge decisions because directors will be able to justify their approach on any of the enumerated factors.[21] This concern is valid but the non-exhaustive list helps to retain flexibility given the dynamic nature of the corporate form. Even so, it is argued that section 172 is not necessarily a positive development because it will be difficult to ensure that the provision has some de facto impact given the limited accountability available.

3. Enlightened Shareholder Value (‘ESV’) approach

An argument in favour of the ESV approach derives from the fact that shareholders are deemed the equity ‘owners’ of the company as they possess control and ownership rights[22] and thus it is justified for decisions to be taken in their interests. In contention to this, it has been argued that equating the shareholders’ interests to that of the company undermines the ‘separate legal entity’ principle which resonates throughout company law.[23] Although Ireland presents a justifiable concern, it is submitted that directors are under onerous fiduciary duties and there needs to be some touchstone as to whose interests are to be prioritised as a matter of effective decision making. One reason for preferring the interests of shareholders has been offered by Bainbridge[24]: under a contractarian approach, the company can be viewed as a nexus of contracts where parties such as employers and creditors contract so as to provide different contributions to the company. Their interests are capable of being sufficiently protected through contract and there is the danger that shareholders will not invest if their interests are not adequately protected. In support of this, it can be said that not only can the interests of other parties be protected by contract but provision is also made under the CA 2006. For instance, under section 247, directors can act to benefit employees and ex-employees in connection with cessation or transfer of undertakings notwithstanding the duty under section 172. Thus, section 172 is required as a matter of necessity to ensure that shareholder interests are protected since other stakeholders’ interests can be protected using alternative mechanisms.

Additionally, shareholder benefits fluctuate depending on the company’s success unlike creditors who are repaid a fixed sum. Shareholders are risking the most through their investment and should consequently be prioritised[25]. Keay[26] has counteracted this by elucidating that shareholders are not the only risk takers; employees take risks by investing in training which is only suited to a particular type of corporation which thereby restricts individual development. In support of this, it is submitted that ‘risk taking’ is not a strong enough justification for prioritising shareholder interests and a better vindication is that when the company is solvent, the shareholders’ interest is at stake and thus their interests warrant protection. Upon insolvency, the creditors’ interests prevail and where a director is guilty of substandard conduct, claims are always actionable by the liquidator under the wrongful[27] and fraudulent trading[28] provisions so as to enforce the creditors’ interests[29].

4. Reform

The strongest challenge to the ESV approach has been proffered by advocates of the pluralistic/ stakeholder management approach (SMA) which was rejected by the Company Law Review Steering Committee[30] before section 172 was enacted. The SMA requires directors to balance the interests of different stakeholders who have contributed to the company[31]. An illustration of this can be found in the Japanese model where the interests of suppliers, employees, creditors and shareholders are to be considered equally by directors in managing the company[32]. Some useful research by Okabe[33] illustrates that the scheme of corporate governance adopted by a jurisdiction correlates with the way it is financed. In Japan, there is a greater reliance on debt funding since companies are controlled and maintained on a long term basis by the main banks.[34] Additionally, the ‘lifetime employment’ tradition in Japan demands a sufficient regard to employee interests.[35] Japanese businesses are also dependent on agreement between the stakeholders; thus, the nature of financing and function of companies necessitates a SMA to protect the highest contributors to the company. Conversely, under the Anglo-American approach, as a corollary of reliance on equity funding, a shareholder-dominated stance seems more appropriate. We should therefore dispel the idea of enacting a SMA given that it is inconsistent with entire purpose of companies in generating wealth for investors.

Furthermore, Odenius[36] identifies that the SMA can be regarded as counterproductive to achieving corporate governance objectives because it presents an inherent conflict between competing considerations. In support of this, it can be said that such a balancing process will render the decision making process convoluted and inefficient so as to detract directors’ attention from ensuring that the company is profitable. Moreover, under a SMA, directors would have a broad power in carrying out their duties and extensive degrees of consideration; this would probably lead to an increase in ‘agency costs’ given that more money will be incurred to monitor their activities[37].

The academic response to section 172 demonstrates a dichotomy between the shareholder and stakeholder value ideologies. The approach embraced by English law establishes a happy medium between these extremes and is an effective way of accommodating the interests of all those involved in the company. The insinuation that section 172 introduces stakeholder management is erroneous since the enumerated factors are merely instrumental to the principal purpose of ensuring that the company is successful for the benefit of the members. Despite its flexibility, it is advanced that section 172 provides guidance, but simultaneously appreciates the need to defer management to directors, and so can be regarded as a positive addition to decision making in the wider scheme of corporate governance.

Bibliography:

Articles:

Paddy Ireland, ‘Company Law and the Myth of Shareholder Ownership’ (1999) 62 Modern Law Review 32

Sarah Bainbridge, In defence of the Shareholder Wealth Maximisation Norm: A Reply to Professor Green (1993) 50 Washington and Lee Law Review 1423

Andrew Keay, Tackling the issue of the corporate objective (2007) 29 Sydney Law Review 577

Roberta S Karmel, Implications of the Stakeholder Model (1993) 61 George Washington Law Review 1156

Yuzuo Yao, Historical Dynamics of the Development of the Corporate Governance in Japan, Journal of Politics and Law (2009)

Books:

Henry Hansmann, The Ownership of Enterprise (Harvard University Press, 2000)

Frank H. Easterbrook and Daniel R. Fischel, The economic structure of corporate law (Harvard University Press, 1st edition, 1996)

Michael Faure, Globalization and private law (Edward Elgar Publishing, 2010)

Len Sealy and Sarah Worthington, Cases and Materials in Company Law (Oxford University Press, 9th edition, 2010)

Paul L. Davies, Gower and Davies Principles of Modern Company Law (Sweet & Maxwell, 8th edition, 2008)

Reports:

Company Law Review Steering Committee, Modern Company Law for a Competitive Economy: The Strategic Framework (1999)

Jürgen Odenius, Germany’s Corporate Governance Reforms: Has the System Become Flexible Enough? (IMF Working Paper, 2008)

Mitsuaki Okabe, The Financial System and Corporate Governance in Japan, Policy and Governance Working Paper Series No. 17 (2004)

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[1] Brady v. Brady [1988] BCLC 20 at p. 40

[2] Gower and Davies (2008), p. 508

[3] CA 2006 s. 170(1)

[4] CA 2006 s. 172(1)(b)

[5] S. 172(1)(c)

[6] S. 172(1)(a)

[7] Companies Act 2006: Explanatory Notes, para. 328

[8] [2001] B.C.C. 494 at [141], [158]

[9] Ibid, [145], [148]

[10] R. (on the application of People & Planet) v HM Treasury [2009] EWHC 3020 at [35]

[11] 170 N.W. 668 (Mich. 1919), per Ostrander CJ

[12] (2010), p. 228

[13] Supra n.8 at [34]

[14] Supra n.2, p. 511

[15] Boulting v Association of Cinematograph, Television and Allied Technicians [1963] 2 Q.B. 606, Lord Denning MR, p. 626

[16] [1992] BCC 863, p. 876

[17] (2007), p. 110

[18] CA 2006, s. 260

[19] IA 1986 s. 212

[20] In Plus Group Ltd v Pyke [2002] BCLC 201

[21] Sealy and Worthington (2010), p. 322

[22] Hansmann (2000), p. 11

[23] Ireland (1999), p. 49

[24] Bainbridge (1993), p. 1442

[25] Easterbrook and Fischel (1996), p. 36

[26] (2007), p. 585

[27] Insolvency Act 1986, s. 214

[28] Ibid, s. 213

[29] West Mercia Safetywear Ltd v Dodd [1988] BCLC 250

[30] (1999), ch. 5.1

[31] Karmel (1993), p. 1171

[32] Yao (2009), p. 169

[33] (2004), p. 6

[34] Ibid, p. 8

[35] Supra n.31

[36] (2008), p. 7

[37] Supra n.25, p. 583