LCCGE Presentation, 28th March 2014 Enlightened Shareholder Value and the Companies Act 2006 Peter N. Taylor Study of corporate governance - not long before come across Shareholder Priority. Not my management experience. Shareholder model neither descriptive or prescriptive. Arrival of ESV and CA 2006 – opportunity to reappraise the shareholder model. 1998: One year into New Labour Government. Fell to New Labour to carry out Law Commission’s recommendation to update law. New Labour – gave a political slant to the whole project. The longest Bill ever considered by Parliament – 1300 sections (2 tonight!) Structure of talk. Narrative. Research project. Conclusions Further work. To kick off - here’s what the DTI said about the plan… LCCGE Presentation, 28th March 2014

CA 2006: a (brief) introduction… “The object of the review will be to bring forward proposals for a modern law for the modern world. The Government is determined that the nation should have and up-to-date framework which promotes the competitiveness of UK companies and so contributes to national competitiveness and increased prosperity” - Modern Company Law for a Competitive Economy, DTI, March 1998 Margaret Beckett also had observed that…law “out of date”. Legislation dating back to the mid-nineteenth century. Right from the beginning, there was a problem: The Law Commission’s plan was that it would be a law reform measure designed to preserve the substance of the existing law where it worked as well, but incorporating improvements in the light of the review process. But, as often is the case, it became the basis for achieving political objectives. This issue (simple improvement versus political objectives ) was at the heart of the difficulties encountered as the process moved from Review to the final Act. I will explain as we go along. LCCGE Presentation, 28th March 2014

LCCGE Presentation, 28th March 2014 CA 2006: the timescale… Steering Group (CLRSG) established in 1998 Four Steering Group reports: - The Strategic Framework - Developing the Framework - Completing the Structure - Final Report (July 2001) Govt. White Papers (July 2002, March 2005) Company Law Reform Bill, 2005 Royal Assent, 8th November 2006 Majority of provisions came into effect on 1st October 2007 Full implementation on 1st October 2009 1998 to 2006 – a long time. Begins with setting up of SG. Steering Group (14 members) – government, lawyers (incl. a High Court Judge), Business, Broadcasters, Economists and Accountants. Consultative Committee of 30 members. Several working groups – one of which was devoted to reviewing the purpose of the company and the role of directors (17 members). That’s the one which concerns us. 2002 White Paper called Modernising Company Law. Didn’t add or clarify much. 2005 White Paper called Company Law Reform. By which time the Government had accepted nearly all SG’s recommendations, including draft clauses on directors’ duties. Interesting to note that the SG wasn’t obliged to do this. Royal Assent was received in November 2006 Majority of provisions (inc. ESV Sections ) came into effect on 1 October 2007. Full implementation on 1st October 2009. LCCGE Presentation, 28th March 2014

The Steering Group’s observations… “ the objective of reform should be to achieve competitiveness and efficient creation of wealth for all participants in the enterprise. At the same time… the aim should also be to minimise the negative impact of corporate activity and to maximise welfare more widely” “the present scheme of law fails … to recognise that businesses normally best generate wealth where participants operate … as teams and that managers should recognise the wider interests of the community in their activities” “…the law as currently expressed and understood fails to deliver the necessary inclusive approach” (Modern Company Law: The Strategic Framework, paras. 5.1.8, 5.1.9 and 5.1.12) … and more… Here the Steering Group is saying what the reform process should achieve and what the perceived limitations are of the existing law. Actually, they said quite a lot, but… So, the law should help to create wealth; it should minimise the downside of corporate activity ,and it should maximise welfare widely . It criticises the failure of the law to recognise teamwork in the enterprise and it fails to deliver the necessary inclusive approach, that is, it fails to recognise the part played by all those involved in the productive enterprise. These extracts are taken from The Strategic Framework, the first SG publication. More - They also noted what they called “the changing relationships among the participants in business activity, etc.” … In a dispersed equity market…. managers could escape shareholder control… shareholding now concentrated… pressure for short-term results… as a result, suppliers of goods and services would less willing to make investments in plant or organisation needed for customer-specific requirements. Inclusivity and the avoidance of short-termism became the key Steering Group issues which the proposed new legislation should address. LCCGE Presentation, 28th March 2014

The Steering Group’s considered options… An “enlightened” version of shareholder value or… A “pluralist” approach SG said that there are two broad forms of argument to deal with these issues… Pluralist approach not Stakeholder theory. Economic benefit only. The Pluralist arguments: several, and a typical example was the observation that … By elevating shareholders to a dominant position … difficult to develop the relationships of trust necessary for the long-term sustainability and efficiency of a business…. equal treatment necessary to ensure that non-shareholder participants could feel confident about making the necessary firm-specific commitments. The Enlightened Shareholder Value argument. Perceived Pluralist advantages could be dealt with within ESV in other ways. In particular trust could be achieved by a normal bargaining process, and in any case an efficient bargaining process should be dealt with by means other than changes to company law. Also, there would be no change in the ultimate objective of companies, as per the Law Commission’s report, 1999… and no fundamental reform of directors’ duties would be necessary and there would be no need to change the rights of shareholders to appoint or dismiss directors. ------------ Outcome: Shareholder Value should be “enlightened “by (i) clear statement of directors’ duties and (ii) greater disclosure of information . LCCGE Presentation, 28th March 2014

ESV: the two statutes. Firstly, directors’ duties… s.172 Duty to promote the success of the company (1) A director of a company must act in the way he considers, 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 (amongst other matters) to – (a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company. Directors must have “regard” to all the items (a) to (f). Let’s look at the Disclosure requirements : Go to Next Slide Return from Slide 7: There’s a problem here… Elsewhere in the Act, in s.170, it says duties are still owed to the company, which was the understanding prior to the Act, so what does s.172 mean? “The general duties specified in sections 171 to 177 are owed by a director of a company to the company”, and it goes on to list them. What’s different? Something new, or simply codification of existing duties? The meaning of s.172 has been much debated. More in a moment. LCCGE Presentation, 28th March 2014

and secondly, directors’ report… s.417 Content of directors’ report: business review (1) - (2) The purpose of the business review is to inform members of the company and help them assess how the directors have performed their duty under section 172 (duty to promote the success of the company). (3) The business review must contain – (a) a fair review of the company’s business, and (b) a description of the principal risks and uncertainties facing the company. Subsection (4) adds more detail and subsection (5) requires quoted companies inter alia, to report on future prospects; environmental matters; the company’s employees and social and community issues. Subsection (6) adds a requirement for KPIs. And there are more…! These two sections – s.172 and s.417 constitute the ESV statutes. This is a summary, because the list of requirements is quite large. Subsection (1) simply refers to which companies are affected – small companies are excluded. s.417 has its own history – previously the OFR, introduced under secondary legislation to meet the EU Modernisation Directive. Note that (5) requires quoted companies to give more information. KPIs required by (6). Theory of this is that full information is critical for an efficient market. Note that important requirement was to audit directors’ duties under s.172. Back to previous slide to discuss Contradiction. LCCGE Presentation, 28th March 2014

Enlightened Shareholder Value: a paradox..? “This clause [of the Bill] does codify and bring into law for the first time duties around corporate responsibility…it is a deliberate act by the Government… for me, the key issue is how we marry the commercial success of … companies with sustainability and social justice.” - Margaret Hodge MP, House of Commons Standing Committee D, 11 July 2006. “There are two ways of looking at the statutory statement of directors’ duties: on the one hand it simply codifies the existing common law obligations of company directors; on the other – especially in section 172: the duty to act in the interests of the company – it marks a radical departure in articulating the connection between what is good for a company and what is good for a society at large.” - Margaret Hodge MP, Minister of State for Industry and the Regions. Ministerial Statement, June 2007. Paradox or Contradiction? Margaret Hodge in the House of Commons. Here we see directors’ duties being influenced by politics – marrying the commercial success; articulating the needs of companies with what’s good for society. Government attacked on selection of duties : “the selection of duties seemed “arbitrary” given that it had been calculated that directors have had some 650 duties laid down through common law and various statutes over the years so why were those six deemed more important than the other 640 – odd?” Margaret Hodge responded : “The clause does not codify all the common law duties… I did not realise we had got to 650. The clause does codify and bring into law … duties around corporate responsibility…. it is deliberate act by the Government.” LCCGE Presentation, 28th March 2014

Enlightened Shareholder Value: a paradox..? “I believe there is a fundamental gap in the Government’s train of thought: either they are introducing a new concept – enlightened shareholder value – which is an extension of the common law, or they are simply codifying existing common law. Ultimately it will be for the courts to determine how far the new duties extend… But any settled case law will take time to develop, so watch this space.” - speech by Jonathan Djangoly, MP, spokesman for the Opposition, given to the Chartered Secretaries’ Professional Group 6th Annual Technical Conference, 5th September 2007. The Conservative Party view expressed by Jonathan Djangoly. The way this Paradox, or Contradiction, was brought to a head is described by Philip Bovey in a paper entitled “A Damn Close Run thing…The Companies Act 2006 (Statute Law Review, 2008 29 (11) (2008)”. “Damn close, because without resolution, the Bill would have collapsed.” Directors’ duties producing … “- Two contradictory responses, sometimes from the same people, one of which would bring an end to capitalism as we know it, or that it would barely change the status quo.” Problem was - “Government had not made up its mind.” About what to do. (Radical change, or simply codification of existing duties) Adjudication by the “brilliant” Attorney general. Interpreted as codifying. But the law is the law, and Jonathan Djangoly is right to say that the ultimate decision rests with the courts. LCCGE Presentation, 28th March 2014

ESV: what the literature said… Problems of definition: “to have regard to”; “success”; “the long term”; “community”; “environment”. Guidance for directors? “Little different” from the traditional model, or a “Third Way”? Gives “legislative permission” to consider interests other than short term. Ensures that “UK law prevents director opportunism”. Problems of legal sanction. Is the Business Review fit for purpose? Definitions. Environment (s.172) or environmental matters (s.417)? Also “impact”. Semantics , perhaps, but all these would demand determination in the courts. Long term – generally accepted, but tricky…ESV does not mean unity of shareholders’ and other stakeholder interests in the long term – it will maintain relationships when it is efficient to do so… Many contributors saw little difference from the traditional model, but Cynthia Williams and John Conley saw it as a “Third Way” - link between s.172 and s.417 to CSR movement – leading them to suggest that ESV was pitched some way between pure USA shareholder model and the more stakeholder –orientated system s of mainland Europe. Legislative permission – legal support for avoiding short-term institutional pressure. Prevents Opportunism - later, as it’s a very significant point. Legal sanction. Reference to s.309. No constituency in s.172 has any standing to pursue directors for a failure to have their interests duly regarded. Business Review – regret at OFR (Johnston) but it will be down to investors to “force” desired information. (Williams and Conley). LCCGE Presentation, 28th March 2014

ESV and CA2006: my contribution… Research Objectives: (1) To carry out an empirical study to ascertain the reaction of public companies and institutional investors to the ESV statutes. (2) To propose a theoretical basis for understanding ESV. So, a mixture of comments for and against. (1) What companies do and propose to do, and how investors have reacted, is the question. First empirical study. (2) Does ESV lead to a better fit than shareholder or stakeholder theories? LCCGE Presentation, 28th March 2014

ESV and CA2006: my empirical study… Methodology (1) Pilot interview Companies - questionnaire - choice of population and sample - in-depth interviews Investors - in depth interviews Methodology (2) - analysis of the principal theories. What fits ESV best? This was the first empirical study. Expectations for “Enlightenment” - lessons from European history. Pilot Interview: Needed to understand more about the law and the interaction between companies and legal advisers. FTSE 350 for three reasons: contribution to GDP; awareness of legislation, involvement in Law Review. Sample was 50%. Aims of questionnaire: 0verall assessment plus guide for interviews. More regard? Short term/long term (s.417?) Risk? [would disclosure in s.417 lead to a moderation in corporate strategy] Legal Advice? Audit trail? Improvements in Shareholder Value? Results of questionnaire – 15% response. No attempt at any statistical analysis . LCCGE Presentation, 28th March 2014

ESV and CA2006: the interviews… Pilot interview (1) Company Interviews (9) - reactions to CA2006 and subsequent action? - change in directors’ responsibilities? - derivative action? - reactions to s.417? - ESV v. SV? - Government policy? Investor Interviews (3) - s.417: how effective? Able to speak to a senior partner of a major London law firm. Company Interviews: questions were notified beforehand. Recorded and transcribed. 45-60 minutes; one 75 minutes. NVivo used to help in analysis. Derivative Action : A Derivative Action is a claim brought by a shareholder against a company’s directors in the name of, and for the benefit of, the company. Prior to CA2006 derivative actions occurred under common law only, but CA2006 saw the establishment of a new derivative claims procedure which widened the scope and which was supposed to make it easier to bring such a claim. Did the objective of making such action more accessible (to any member) affect decision-making? Were they scared of being sued? Government Policy: what did they think of the “articulation” argument – marrying success of the company with the needs of society. Investor interviews: Assumed that s.417 was important to them. Did it provide them with the information required to understand company, and the performance of its directors under s.172(1)? LCCGE Presentation, 28th March 2014

ESV and CA2006: summary of results… Pilot interview… - “a good director before 1 October 2007 would be a good director now”. - s.172(1) trying to “instil a state of mind”. - board decisions to be minuted with a “paper chase” about decision processes. - senior managers’ need to be aware. - the aim of s.172(1)… “to help directors understand their responsibilities”. - “to treat the new duties as a mere codification may be reassuring, but it hides the subtlety and significance of changes”. Paying lip service … is not sufficient”. Not going to take you through 60 pages of narrative, charts and analysis (though I do have one table later) but here is a summary. The result from the Pilot was very informative. Advisory documentation handed over. Very comprehensive. A key point is the last one here. The deduction was that “there was a case to answer”. LCCGE Presentation, 28th March 2014

ESV and CA2006: some conclusions… The result is not zero. ESV in CA2006 taken seriously by FTSE350 sample. No improvement expected in shareholder value, but … Majority have improved formal procedures for Board paper preparation. Some indication of an increased aversion to risk. No concerns about derivative action (s.260), but… Business Review: limited value to investors. Brief look at next slide. Responses to 172 (1) (a) to (f). Legal Advice /Auditors’ advice in all cases. Training, awareness of Act. ..but it doesn’t mean that ESV is the same as SV. Not in all cases, but most had implemented formal procedures , including instructions for subordinate levels of management. Awareness to lower levels. Check lists. Quality systems. Safety systems. Some companies said they would be more careful about making decisions. The need for forward-looking statements in s.417 increased potential for challenge. Evidence of some non-executive directors asking for higher fees and difficulty in recruitment. 7. “Boiler Plate”. Difficult factors ignored. Often just operational matters covered strategic one omitted. Response of an oil company. LCCGE Presentation, 28th March 2014

ESV and CA2006: summary of results… Questionnaire results: directors’ duties… Of the 26 replies, six companies indicated that the Act would cause them to have a greater “regard” for s.172(1) (a) to (f). Of the six, two replies indicated a greater regard for one, two replies for two, and two for all six requirements of the Act. As I said, with such a small response you can’t make definitive deductions, but the fact that the ESV statutes show a positive response at all (plus all the others) means that the result is not zero. It would be interesting to repeat the question now. LCCGE Presentation, 28th March 2014

ESV and CA2006: conclusions… Factors to be taken into account for a theoretical perspective… the political view of enlightenment. the literature critiques of enlightened shareholder value. the analysis of shareholder and stakeholder theories, and others, as the competing forces for the dominance of corporate governance. the empirical work of this study. The conclusion was reached that enlightenment is best viewed as a theory which preserves the integrity of the shareholder model by mitigating against the possibility of market failure. Second Part of Research Question… Bringing together… Political view: combining the needs of society and business. The recognition that such a theory may not be prescriptive , covering all directors’ common law and statutory obligations. Taking account of the limitations of shareholder and stakeholder theories, yet recognising their importance to the sustainability of the enterprise. The regard shown for non-shareholder interests in both the questionnaire responses and at interview. Shareholder and stakeholder theories are partial theories, serving the interests of their respective constituencies. Sometimes they converge, sometimes they conflict. What is needed is a theory which embraces both. By an inductive process, I came to the conclusion that a market failure model is the best explanation for Enlightened Shareholder Value. Enlightenment can there fore be considered as a mechanism which helps to sustain the corporate enterprise, mitigating against market failure and supporting the integrity of the shareholder model. Read from slide: “Market failure… The theory of Market Failure was, I thought, a good fit. LCCGE Presentation, 28th March 2014

ESV and CA2006: subsequent work… Additional literature critique: Williams, R. (2012). ‘Enlightened Shareholder Value in UK Company Law’ (UNSW Law Journal, 35,1, 360-377). Further empirical study: ‘The Enhanced Business Review: Has it made Corporate Governance more Effective?’ (Villiers, C. and Aiyegbayo, O. (2011). Journal of Business Law, 7, 699-724.) Additional contributions on effectiveness of Derivative action: Keay, A. and Komin, L. (2014). Directors’ Duties. Chapter 14. Jordans. Further theoretical work: ‘An Analysis of Enlightened Shareholder Value in Light of Ex Post Opportunism and Incomplete Law’ (Keay, A. and Zhang, H. (2011). European Company and Financial Law Review, 8 (4), 445-475.) Richard Williams. Takes a dim view of the prospects for management change in the UK. “Little appetite on the part of the courts or state for fundamental change in the expectation of directors. “ Rather than focusing on ESV, therefore ,he suggests that the UK disqualification rules are a more useful blueprint for reformers in other jurisdictions who wish to see greater protection for third party interests within a shareholder-orientated corporate governance framework. Villiers and Aiyegbayo. Study of Business Review. Legislation has enhanced narrative reporting . Forward-looking reports too cautious . Fear of litigation leading to “boiler-plating”. Paradoxically, they say, that could lead to litigation because directors are required to express honest opinions. Keay and Komin. Detailed descriptions of legal procedures and case histories. Not surprising that as at September 2013 only 14 cases had been and 5 had been refused permission. Keay and Zhang. Explain ex-post. The flip-side of my conclusion. ESV according to Andrew Keay acts as a moderating influence on any propensity of a director to take advantage of opportunities outside contractual arrangements. LCCGE Presentation, 28th March 2014

Enlightened Shareholder Value: some reflections… How is the evolution of Shareholder Value underpinned by law in other jurisdictions? Can the law make a contribution to the ethics of corporate governance? LCCGE Presentation, 28th March 2014

LCCGE Presentation, 28th March 2014 Enlightened Shareholder Value and the Companies Act 2006 Peter N. Taylor LCCGE Presentation, 28th March 2014

Analysing ESV: a model for governance… …relating three components of corporate governance: LCCGE Presentation, 28th March 2014