Secondly, in most countries the tendency in recent years has been to increase the statutory requirements for corporate disclosure and the regulation of corporate affairs. Further, the tendency to resort to civil litigation has been increasing. The threat of court action has become a significant element in the corporate governance process in some countries. This has been particularly the case in the United States, where class actions (that is the ability to join all members of a class, such as shareholders, in a single action) and contingent fees (that is the process of a lawyer offering to take a case on the basis of tees contingent on the success of the case and the size of any damages awarded – a practice, incidentally, that is prohibited in many other countries) have encouraged such litigation. But other countries, such as the United Kingdom, Australia and Canada, have also seen significant increases in actions being brought against companies, their auditors, their boards and individual directors by shareholders and others alleging, Inter alia, negligence and directors' failure to exercise their proper duties of care and trust.
Thirdly, despite the significant differences in the legal position of directors between jurisdictions, there are a few very general points that are broadly applicable to directors everywhere.
E. Responsibilities to the Shareholders
In most cases directors are formally appointed by the shareholder members of the company. As we saw in Chapter 1, ownership is the underlying basis of power to nominate and elect directors, even though in practice nominations for new board members may come from the incumbent board, which might also fill casual vacancies. Nevertheless the shareholders, meeting together in a properly convened meeting, typically hold the confirming power. Exceptions to the general rule of shareholders appointing directors include some state-owned corporations where the government exercises that power under the relevant statute, and where the articles of association of a company provide otherwise.
Consequently, a director's basic responsibility is to the shareholder members. As we will explore subsequently, boards need to provide strategic direction for the business, setting relevant policies, and to supervise the activities of top management. Further, the board is required to be accountable to the members, including the requirement to present regular reports and accounts, duly audited in most cases, in the statutory form. In some jurisdictions these accounts are filed and are available for public inspection.
F. Directors' Obligation to Honesty and Integrity
In almost all jurisdictions a company director is expected to act with honesty, integrity and candour towards the company – in particular its members. This fiduciary duty is to the company as a whole. In practice this can be difficult if, for example, a dominant parent company exercises power over a subsidiary in which there are minority outside shareholders. Decisions must be taken in good faith for the common good. British-based common law allows directors to determine the best interests of the whole, subject to the right of appeal to the courts; directors of American companies owe specific fiduciary duties to any minority shareholders.
The primary duty, in other words, is to act honestly in good faith, giving all shareholders equal, sufficient and accurate information on all issues that could affect their interests. Directors may not treat a company as though it exists for their personal benefit.
A director, consequently, must not make a secret profit out of dealings with the company. His duty is to disclose any such interests to the board and to abide by their decision as to what is in the company's best interests. Insider trading, that is dealing in the shares of a quoted company, on the basis of privileged, price sensitive information is considered improper in all jurisdictions and is a criminal offence in most (though not all).
A further duty imposed on directors, either by statute or case law, is the duty to exercise reasonable care, diligence and skill in their work on the board. The interpretation of what constitutes such reasonable skill and care varies between countries. A general proposition is that the standard of professionalism now expected of directors, around the world, is significantly higher than a few years ago. Courts will act if fraudulent or negligent behaviour is alleged, or where there seem to be abuses of power by directors: it is not the role of the courts to second guess commercial judgments made by directors, even though by hindsight they have been misguided.
G. Theories of Corporate Governance
The original corporate concept enshrined a philosophical assumption about the nature of man, one that has been reflected in subsequent developments of company law – a view that man is essentially trustworthy, able to act in good faith in the interest of others with integrity and honesty. This is implicit in the fiduciary relationship required of directors. Certainly checks and balances are involved, but only to catch the occasional rogue.
This perspective has been termed stewardship theory (Donaldson and Davis 1988) and is consistent with some behavioural theories; for example with theory Y of Macgregor, whose principal propositions include:
1) that management is responsible for organizing the productive elements – men, machines, materials and money – in the interests of economic ends;
2) that people are not by nature passive or resistant to organizational needs;
3) that the motivation, the potential for development, the readiness to direct behaviour towards organizational goals are all present in people.
However, one of the earliest studies in the field of corporate governance, by Berle and Means in 1932t provided a challenge to the conventional assumptions of stewardship theory. They pointed out that] ownership in large public companies had become separated from management. No shareholder owned significant proportion of the equity capital. The top managers themselves held only very small stakes, if J any. Consequently the shareholders were no longer able to monitor the affairs of the business in which they had invested – they had surrendered their control to management. Moreover, the interests of owners and management was likely to diverge – the former seeking increased corporate worth reflected in share price and dividend stream, the latter in job security, reward packages, and other personal benefits.
Berle and Means contended that managers did not have the same interest and motivation as the owners to make full and efficient use of the corporate assets. Consequently the owners had to introduce other means to ensure an alignment of owners and managers interests. Jensen and Meckling (1976) extended the argument by assessing the agency cost of this alignment. They define the shareholder relationship as one of agency: a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers there is good reason to believe the agent will not always act in the best interests of the principal.
Such a perception has become the underpinning of agency theory, now an important component of the literature of financial economics. The agency theoretical view is that an agent will not take decisions which attempt to maximize the long-term value of the firm, but rather will take decisions out of self' interest to benefit the agent to the detriment of the principal.
The view of man taken by agency theory, by contrast to stewardship theory, is that people cannot be trusted to act in the public good in general and in the interests of the shareholders in particular: they need to be monitored and controlled to ensure compliance. Such check and balance mechanisms, obviously, incur agency costs. Jensen and Meckling argue that firms should incur such agency costs of enforcement to the point at which the reduction of the loss from non-compliance equals the increase in enforcement costs.
Examples of such agency costs being incurred in practice include board structures which emphasize outside, independent directors, committees of the board comprising independent directors to be concerned with audit, top management remuneration and the nomination of new directors, and the separation of the 1 roles of chairman and chief executive officer.
Elaboration of agency theory applied to governance issues is contained in the readings.
Further theoretical insights relevant to corporate governance on an international dimension may be found in cross-cultural studies. Research in this area has hardly begun, but suffice it here to comment that both stewardship theory and agency theory are Western in context, assuming rational, unemotional, contractual relationships based on the desirability of order with appropriate procedures and rules, with participative and open styles of relationship and ready access to information. Corporate governance in other parts of the world, throughout most of the Pacific Basin for example, must be practiced within different philosophical traditions, where responsibility, ready acceptance of hierarchical control, respect for authority, paternalism, collectivities rather than individual, and secrecy may be the norm.
Task 2. Talking Point 1
Work in groups of three, consult Speaking References p.126–130 and discuss the following:
▪ What qualities/features does deciding on board nominations depend on?
▪ Expand on being “the wise man”, “the specialist”, “the window-on-the-world”.
▪ Expand on being “the contact-person”, “the figure-head role”, “the status-provider”.
▪ Expand on being “a judge”, “the catalyst”, “the monitor or supervisor”, “watchdog role”, “confidant”, “the safety-valve”.
▪ How much do the basic companies ordinances differ in different countries? Take into consideration: laws rooted in Roman law/within the case-oriented legal structures.
▪ What is the underlying basis of power to nominate and elect directors?
▪ Who does hold the confirming power?
▪ What are the basic responsibilities of the shareholders?
▪ Expand on acting honestly in good faith
▪ What are the main duties imposed on directors?
▪ What is the nature of man in accordance with the original corporate concept?
▪ Expand on stewardship theory/Criticism on “stewardship theory
▪ Expand on the agency theory.
Task 3. Reading 2
Getting started
▪ Before reading the text, discuss in small groups what role plays the board of directors in the governing the company.
▪ Skim the he text to find out if your ideas are similar to those in the text.
▪ While reading the text, pay attention to the words in bold and try to explain them. Consult Vocabulary p. 139–140.
▪ Title the text.
The board of directors of a limited company is primarily responsible for determining the objectives and policies of a business. It is the directors who determine the direction the business is going to take. They will need to ensure that the necessary funds are available and will appoint key staff to whom they will delegate the authority to run the business on a day-to-day basis. They will need to design an effective organisation structure so that there is both a chain of command linking one level of management with another and an effective communication network so that instructions can be passed downward and information passed upward.
The directors are appointed by the shareholders, normally at the company's annual general meeting, at which the chairman of the board will be expected to account for their stewardship during the previous year. The company's accounts will be presented to the shareholders at that time so they can judge for themselves whether or not the board has been successful.
Direction in business is like strategy in a war situation. The strategic decisions determine the areas in which the company's resources will be employed. Above all it involves planning to ensure that the business first survives and then flourishes. Strategic decisions, made by the board of directors, are concerned with the disposition of resources. These contrast with the tactical decisions by means of which the senior executives (appointed by the directors) carry out in detail the plans conceived or approved by the board of directors.
The fact that boards of directors tend to meet rather infrequently, say once a week, means that part-time directors can be elected to the board. Since they will not have departmental responsibilities within the company they are often described as non-executive directors. There are arguments in favour of such directors though they may lack a detailed knowledge of the company's activities. They may bring expertise to the board. Some are lawyers, or experts in tax affairs. Some represent influential groups of shareholders whose support is necessary if the board is going to carry out its plans, while others are directors in a number of companies and are used to interlock boards within a group of companies. For example, a holding (or parent) company may appoint a director from their board to serve on the board of a subsidiary company, with a view to keeping a watching brief on the directors' activities.
Task 4. Talking Point 2
Work in groups of three, consult Speaking References p. 126–130 and discuss the following:
▪ Why delegating is used in running the business?
▪ What role do the senior executives play in the company?
▪ What happens at the annual general meeting?
▪ What is the difference between a strategic and a tactical decision?
▪ What part can non-executive directors play in the proceedings?
▪ What is meant by an interlocking board of directors?
▪ How is it that a board of directors can control a company though they only meet, say, once a week?
Task 5. Vocabulary 1
A. Match the phrases from the text (1–9) to their definitions (a– i).
B. Fill in the blanks in the text below, using the words from the box:
link, company’s, actively, coming, increase, delay, sell, company’s, capital, provided, run, spent, certain, mixture, brand, overseas, combines, course, coming, faced, benefit, appointed, marketing, financial, general, advertising, complex, buy, directors, management, post, appointed
EXECUTIVE DIRECTORS
A modern business enterprise is often a system requiring a lot of ______, which is provided by the public when they _______ shares in the company. Since they have _______ the capital, it is appropriate that they choose the people who are to _______ ________ the company for them, namely the board of directors. Many of the_______ also have executive responsibilities.
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