Sitting comfortably in the boardroom?

With the impending company law reforms, Gary Slapper analyses the extent to which individual shareholders and pressure groups could exert their power, and ponders whether directors are likely to face voluminous new litigation as a result

“The shares are a penny, and ever so many
are taken by Rothschild and Baring,
And just as a few are allotted to you,
you awake with a shudder despairing.”
WS Gilbert, Iolanthe (1882)

In contrast with the shareholders who listened to the line in the first performance of the Gilbert and Sullivan operetta in 1882, shareholders today are a much bigger part of society, and significantly more empowered.

Impending company law reforms that fortify shareholders’ rights have produced anxiety in the UK business community about the threat of litigation against directors.

Clauses within the Company Law Reform Bill, specifically Clauses 156, 159 and 239 concerning directors’ duties, have been singled out as an indication that the UK could be on the slippery slope to US-style litigation. What are the fears concerning the clauses?

Many people in business and corporate life dread the prospect of any further encroachment of law on business. Lawyers have never been society’s most popular professionals. In an episode of the television cartoon series Futurama, during a riot, one of the characters looks at a body on the ground and exclaims to another character “You killed my lawyer!”, to which the instant reply is “You’re welcome”.

The forthcoming legislative changes come at a time when shareholder power has manifested itself in several dramatic instances, both in the US and in the UK. In March 2004, for example, Michael Eisner, the chairman and chief executive of Disney, gave up his position as chairman when 43% of shareholders voted against his re-election. Shareholder activism increased after the crash of the corporate giants Enron and WorldCom and exposure of their “creative” financial practices. Congress responded with the Sarbanes-Oxley Act, effective from 2002, which made new loans by a company to its executives illegal, and established a supervisory board for accountancy in the US.

In the UK, the Directors’ Remuneration Report Regulations 2002, amending the Companies Act 1985 (S241A and Schedule 7A), required the disclosure of directors’ pay. Since then, all FTSE350 companies have put their remuneration reports to a separate shareholder vote.

Shareholder activity has been bold. In 2004, following considerable shareholder anger, Sir Philip Watts, the chairman of the oil giant Shell, resigned. The Anglo-Dutch company had shocked shareholders by revising down by one-fifth the group’s proven reserves. Investors were implacable.

The Company Law Reform Bill, when promulgated, will mark a major change in the legislative framework in the UK. Company regulation has had a long evolution. The Company of the Mines Royal, for example, founded in 1564, was organised on a joint stock basis from its inception. The Government established the Company Law Review (CLR) in 1998 to consider how company law should be modernised. Following wide consultations it reported in 2001, and the draft legislation which applies to all of the UK is based on its recommendations.

The general duties of directors

The general duties will be stated in a code of conduct, setting out how directors are expected to behave. It does not tell them, in terms, what to do. The duties are derived from common law. The new law is designed to address the key question of “in whose interests companies should be run”.

It will be important for a director to understand the purposes of his company, to comply with his duty, in Clause 156, to promote its success. This clause states: “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...”

The clause goes on to say that, in fulfilling the duty, a director must (so far as reasonably practicable) have regard to certain factors. These are: (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, therefore, will have to act with great caution. However, under Clause 159, transactions or arrangements they make with the company will not have to be authorised by either the members or the board. Instead, interests in such activity must be declared under Clause 161 (in the case of proposed transactions) or under Clause 165 (in the case of existing transactions) unless an exception applies under those clauses. Clause 159 also permits board authorisation of most conflicts of interest arising from third-party dealings by the director (like personal exploitation of corporate resources and opportunities).

The CLR took the view that the current strict rule relating to conflicts of interest in respect of personal exploitation of corporate opportunities fettered entrepreneurial activity by directors. The legislation therefore provides for board authorisation of such conflicts.

Derivative claims by members

The bill does not overturn the old established principles. Clause 239 sets out the key aspects of a derivative claim. The action is brought by a member of the company, the cause of action is vested in the company, and relief is sought on the company’s behalf. A claim “may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company”. As such, a derivative claim may be brought in respect of an alleged breach of any of the general duties of directors, including the duty to exercise reasonable care, skill and diligence.

Whether these provisions will produce a growth in litigation against directors remains to be seen. Improved clarity of rules, and directorial circumspection, could result in a fall in shareholder complaints. Moreover, the duties are not stringently objective: the director “must act in the way he considers, in good faith, would be most likely to promote the success of the company.” Additionally, Clause 159 affords some leeway to directors.

The UK is not as litigious as the US. There has been a decline in general litigation in the UK over the last 10 years. Britain spends less on compensation than any other industrialised country. According to statistics published by the Department for Constitutional Affairs, 153,624 writs and originating summonses were issued in 1995 in the Queen’s Bench Division of the High Court. By 2004, the figure was 14,830. The vertiginous general drop in cases going through court implies that more cases are being abandoned or settled out of court.

In the American television cartoon The Simpsons, the unscrupulous lawyer, Mr Hutz (whose practice is called “I Can’t Believe It’s a Law Firm”) engages in tutoring at “The College of Litigation”. On one college leaflet it says: “Tired of gambling week after week on lotteries? Embezzlement too risky? Blackmail too unsavoury? Why wait - litigate!” However, in the UK, under the forthcoming act, it is unlikely that shareholder litigation will rise steeply. That is because proving a significant dereliction of directorial duty according to the new rules will be sufficiently difficult and expensive to deter all but clearly meritorious cases.

Gary Slapper is professor of law, and director of the Centre for Law, at the Open University.