Corporate Governance Company Law Notes (FULL)

Corporate Governance Company Law Notes (FULL)

Read the full corporate governance company law notes that were prepared for exam revision by a student from a top UK university. These notes are meant to supplement and not replace your revision.

Corporate Governance

Concerns the question of who should own and control the company and at its narrowest, it purely concerns the relationship between the shareholders and the directors.

Introduction to history and evolution of corporate governance theories

18 and 19 century business landscape was largely filled with unincorporated business associations in which individual owners were also the controllers-traditional enterprise model.

Some large and statutory companies existed and were important in providing a model for the emergence of the registered company but they were by no means the dominant business form.  Owners were also managers. The emergence of the registered company provided these traditional enterprises with access to incorporated status and slowly the corporation became the normal means by which business operated.

The registered public company with its ability to facilitate large-scale investment with minimal risk to the investor was easily available. The emergence of a corporation where ownership was separated from control. Chandler 1990:

‘the building and operating of the rail and telegraph systems called for the creation of a new type of business enterprise. The massive investment required to construct those  systems and the complexities of their operation brought the separation of ownership from management. The enlarged enterprises came to be operated by teams of salaried managers who had little or no equity in the firm. The owners, numerous and scattered, were investors with neither the experience, the information, nor the time to make the myriad decisions needed to maintain a constant flow of goods, passengers and messages. Thousands of shareholders could not possibly operate a railroad or a telegraph system’.

Arrival of a successful managerial class in the large-scale transport and communication companies.

KEY: Bearle and Means (1932) made 2 key observationns about the operation of American companies in the 1930s.

1 shareholders were so numerous (dispersed ownership) that no individual shareholder had an interest in attempting to control the management.  65% of the largest 200 US companies were controlled entirely by their managers.

2 they expressed concern that managers were not only unaccountable to shareholders but exercised enormous economic power which had the potential to harm the society. Mizruchi 2004 describes: ‘it was also concerned about managers’ lack of accountability to society in general. Berle and Means thus wrote of a small group, sitting at the head of enormous organisations, with the power to build and destroy communities, to generate great productivity and wealth, but also to control the distribution of that wealth, without regard for those who elected them (stockholders) or those who depended on them (larger public)’. Managerial companies continued to grow and became dominant form of the 20 century. 1970s the legitimacy of managerial corporation was increasingly questioned and by 1980s a change was occurring in the way shareholders were behaving. Institutional investor emerged as a dominant force in those markets- holding nearly 80% of the shares in the UK market and 50-60% % of the shares in the US market by the late 1980s. Largely passive investors..favoured market mechanisms in order to promote shareholder wealth maximisation. Bearle and Means corporation is undergoing transformation as the largest shareholders become more active.

Concession and fiction theory

The state had the dominant role in the formation of companies through charter or statute led to the view that the company was a concession or privilege from the state. The concession theory is also linked with the fiction views the corporation as a legal person than a natural one thus it is a fiction. Concession and fiction theories are therefore bound together.

  • Weakness of concession and fiction theories- little to say on the subject of the private individuals behind the corporation
    • The arrival of the registered companies in the mid-19th century made incorporation a simple matter of registration rather than requiring a charter or Act of Parliament à weakness apparentà other theories arose to challenge dominance of concession and fiction theories (better equipped to deal with diminished role of the state in company formation

Aggregate theory

Aggregate theory drew on Roman law surrounding the Roman Societas (association) which had legal personality

Societas directly influenced common law partnerships and Continental societe en commandite (entities formed by individuals who agreed to associate with each other for a common purpose)

  • Emphasised the real persons behind the corporation: the law was not central to formation of the company à the company was an aggregate of the individuals who had contracted for its formation à the private individuals behind the aggregate are the focus of the corporations rights and obligations
    • Two significant claims:
      • Companies are formed by private contracting individuals therefore state interference in such a private arrangement is difficult to justify- interference with individual’s freedom to contract
      • Justifies the primacy that company law gives to shareholders as the key contracting individuals behind the corporation
    • Managerial company aggregate theory evolved out of the aggregate theory because:
      • Shares became increasingly transferable and shareholders behaved more like speculators than ownersà idea that a legally binding contract was behind the corporation loses legitimacy
      • Separation of ownership from control made relating the company only to its shareholders a less adequate position
    • Weaknesses of aggregate theory
      • Emergent increase of managers powers sees a decline in the shareholders’ influence + a general sense that corporation now an entity in itself, affecting much wider constituency than just its shareholders
      • Difficulty in explaining corporate personality- ignores the fact that company owns its own property and fiduciary duties are owed to the company

Corporate realism

  • Originated from 19th century German theorists who considered the company to have a ‘real’ separate existence from its shareholders –once a collective is formed takes life of its own and cannot be referenced back to its members
    • The collective has interests and objectives which may not change even though the members of the collective may change many times over
    • Shareholders have no primacy in the realist model- the company’s interests and objectives as defined by its managers are paramount
      • To a very large extent legitimizes the manager-dominated companies that arose at the start of the 20th century
    • Weaknesses of corporate realism:
      • Does not deal with managerial accountability because it assume a neutral disinterested management (contrast with aggregate theory which solves this by advocating shareholder primacy –that managers are accountable to shareholders)
      • Leaves unanswered: what are the interest of this ‘real person’ if they are not equated with the shareholders?
      • These deficiencies largely unchallenged until post 1930s great depression
        • Berle and Means (1932) – ‘The Modern Corporation and Private Property’ + debate between Berle and Dodd in the Harvard Law Review à shapes the course of the corporate governance debate significantly
        • Dodd set out a corporate realist model- company a real person not an aggregate of its members
          • As a real person has citizenship responsibilities requiring personal self-sacrifice, a corporation has social responsibilities which may sometimes be contrary to its economic objectives
          • Managers of this citizen corporation expected to exercise powers in way that recognises company’s social responsibility to employees, consumers and the general public
          • This pluralist formulation rejects the notion of shareholder primacy and provided a clear basis for the separation of ownership from control
        • Berle challenged Dodd’s solution as too vague- practically unenforceable and would lead to increase of managerial dominance
          • Focused the company’s accountability mechanism on just the shareholders à proposed an aggregate theory where managers are trustees for the shareholders not the corporationà managers are accountable to the shareholders and shareholder wealth maximisation is the sole corporate interest
        • The outcome: These two views shaped the debate until 1960s
          • End of WWII success of managerial companies caused the Berle thesis much difficulty
          • No legislative intervention in the USA to promote Dodd’s pluralist approach but managerial companies appeared to be able to act like corporate citizens and balance the needs of shareholders, employees and the general public
          • 1959 just as evidence was emerging that supported Berle’s position on lack of managerial accountability in a pluralist model, he gave up and adopted a pluralist approach (FAILBLOG)

Economic Theory

  • By 1970s global economy changes affect the managerial company’s ability to balance these different constituencies (namely; shareholder, employees and general public) à aggregate theories were redeveloped by economists, once again challenges corporate realism
  • Primary concern is efficiency- two types: resource allocation efficiency and production efficiency (maximised output) à economic theory can test whether a company is operating efficiently or whether company law is promoting efficiency
  • Neo-classical economic theory did not recognise the firm- viewed as purely an individual capable of operating in a marketplace- no real insight into the separation of ownership from control
    • The study of markets leads to 4 important suppositions:
      • The market is the price setting mechanism (supply vs demand), any state interference with this mechanism will cause inefficiencyà justifies limiting the state’s role in regulating both markets and the firms operating in them
      • The market itself is perfectly competitive- no barriers to entry, homogenous goods
      • The firm has only one objective that is profit maximisation (both short and long term) à pursues this goal without referring to response of other firms in market
      • The firm has perfect information about all present and future events that would influence its activities à allows firm to act in perfect certainty and make rational profit-maximising choices
    • Weaknesses of neo-classical theory:
      • Makes fundamental assumptions (above) that may not bear any relation to reality- the managerial company caused great difficulty for this theory:
        • Large size of these companies meant imperfect competition
        • If management is purely responding to market stimulus in a rational profit-maximising way then the separation of ownership from control has no significance à management is either neutral or a pure agent for the market’s price mechanismà no managerial discretion
          • This is the same position as owner-managed companies
        • KEY: does not explain difference between owner-managed and manager-dominated companies
      • Baumol (1959) offered a narrower managerial model- manager’s salaries, corporate rankings and managerial prestige tied to sales revenueà sales revenue maximisation had become the primary goal of the managerial firm (not profit-maximisation)
        • Recognised there were both internal and external constraints on managers’ discretion
          • Dispersed shareholders might leave managers to pursue their sales objectives as long as a certain amount of profit went back to themà if this does not meet their expectations then they may remove them and replace them with managers who would meet these expectations
          • Threat of hostile takeover (see takeover regulation essay + effect of the hostile takeover on the market for corporate control)
          • Managers had to exercise discretion to achieve ‘profit satisficing’ for their shareholders – to provide the minial amount of profit necessary to stop them from exercising their removal power or selling their shares
        • Manne (1987) utilised a managerial market-oriented analysis- argues that managers were more accountable to shareholders than was assumed
          • That managers have to behave in order to:
            • Tap capital markets in the future
            • Enhance both their own reputation and the firms
            • Deter takeovers

By the 1970s global economic conditions had made the managerial firm a focus of discontentà no longer seen as fulfilling a corporate citizenship roleà the very legitimacy of the managerial firm was increasingly questioned

  • Coase (1937) who wrote on the nature of the firm during the Great Depression influential in the 1970s
    • Primary concern: the failure of neo-classical economics in dealing with the organisational nature of the firm ‘why are there these islands of conscious power?’ à if the market is the price setter, how come the decision making process in the firm operates before the market-price mechanism operates
    • KEY: Costs to the individuals who operate in the marketplace:
      • Uncertainty is inherent in contracting in marketplace –contrary to neo-classical assumption of rationality; they DO NOT operate with perfect knowledge
      • Individuals had to spend money to acquire information and enforce contracts because of this uncertainty
      • According to Coase, the firm was a solution these uncertainties because it mitigated the effect of transaction costs:
        • Inside the firm relationships were more certain because of higher co-operation
        • Individuals came together to minimise costs in the firm under direction of an entrepreneur who would co-ordinate the resources of the firm

Importance of Coase’s work: recognised that firms were not individuals operating in the marketplace (as assumed in neo-classical theory), nor did market equilibrium forces simply flow through it à had to be analysed differently

‘isn’t the market responsible for allocating all resources efficiently without the intervention of any authority? In fact, Coase (1937) taught us that using the market has its costs and firms alleviate these costs by substituting the price mechanism with the exercise of authority. By and large, corporate governance is the study of how this authority is allocated and exercised. But in order to understand how this authority is allocated and exercised we first need to know why it is needed in the first place. We need thus, a theory of the firm’ –Zingales (2000)

  • Alchian and Demsetz (1972) attempted to provide such a theory of the firm- taking issue with Coase’s transaction cost theory by disputing the primary role of the entrepreneur in the firm
    • The firm was in fact a marketplace within which management did not direct or authorise- rather, constantly renegotiate the contracts within the firm
      • KEY: describes the firm as a NEXUS OF CONTRACTS where there is equality of power therefore no hierarchy à in the process of constant renegotiation, both sides are satisfied with the outcome
      • Recognized one key difference between markets and the firm: that the firm operates as a non-hierarchical team of workersà as they work together there is opportunity for members of team to become inefficient à a monitoring agent is needed to maintain efficiency
        • Shareholders forced to carry out this role- the Alchian and Demsetz firm palces the shareholders in the key role of monitor and directly attacks the managerial firm as being inefficient because it is unconstrained by shareholders
          • Managerial firm does not contain the necessary mechainisms to focus managerial power on objective of profit-maximisation

Agency Cost Theory

  • Jensen and Meckling (1976) added to the Alchian and Demsetz nexus of contracts- the relationship between the shareholders and management was that of agent and principal
    • Managers know more about the firm than shareholders à shareholders incur ‘agency costs’ in order to acquire sufficient information about the firm’s operation to check on management
    • Shareholders will only bear agency costs if their dividends from firm are greater than the cost of monitoring à agency cost increases as management’s ownership decreases
      • Managerial firm where management have no significant ownership the agency costs are highest
    • A number of market-oriented factors diminish agency costs
      • The efficient operation of the market for corporate control acts as a restraint on management – if agency costs too high will be reflected by low share price-à takeover bid will replace inefficient management
    • Williamson (1975) developed a different theory similarly dealing with work of Coase – transaction costs borne by those operating in marketplace illustrates that markets were imperfect
      • Extended analysis: shareholder primacy is justified because they are unable to renegotiate their position (buys shares without contractual agreement that management will maximise profits
      • Organisational structure of the firm also formed to protect the shareholders risk and ensure their claims


Nexus of Contracts theory

  • Largely a reformulation of aggregate theory- BUT adds considerations based on economic efficiency to attack the managerial firm and the pluralism of corporate realists like Dodd
  • The firm is reduced to contracts and markets – the firm is not a real person thus no interests of its own into which corporate social responsibility can be placed
    • Also, the allocation of resources by management to social issues would be inefficient as the monitoring mechanism within the firm in a nexus of contracts analysis ensures efficiency through a presumption that shareholders maximise their own self-interest
  • Strengths: can provide clear certain answers to many aspects of corporate behaviour
    • Easily solves managerial accountability issues
    • Cheffins (1999) woke company lawyers up
  • Weakness: Still cannot accommodate the fact that directors owe fiduciary obligations to company not shareholders + that companies own their own property

1980s nexus of contracts or a Williamson/Coaseian analysis -pervasive application

  • Agency cost theory concurrent with growth of institutional investors as the largest shareholders in the US and UK – inst investors preferred market-orientated solutions because it minimises monitoring costs
  • Shareholder-oriented accountability became the active focus of inst investors- promotion of agency cost reducing monitoring mechanisms
    • Share options
    • Non-executive directors
    • Hostile takeovers
  • Corporate realist idea of corporate citizenship declined in influence because of the above (private sector and gov focus on promoting market-based solutions)

Late 1980s recession challenges shareholder focus- disquiet on the detrimental effect market-based solutions have on stakeholder constituencies (employees, customers, general public)à STAKEHOLDER efficiency arguments arose

  • Freeman and Evans (1990) stakeholders are risktakers similar to shareholders therefore organisational structure of firm should reflect this
  • Easterbrook and Fischel (1991) maximising profits for shareholders automatically benefits other constituencies by creating wealth – jobs, wages, goods, services for consumers (but unoriginal cos Friedman (1962) always said this)
  • Hill and Jones (1992) a ‘stakeholder agency theory’ to justify a wider focus for managerial discretion
  • Hansmann and Kraakman (2000) adopting a nexus of contract approach at start, emphasise the proprietary nature of firms à points out that company law enables company to own its own assets à not possible for contract, property or agency law to achieve a key aspect of corporate behaviour they call ‘affirmative’ asset partitioning
    • Not only does limited liability protect the shareholders form the company’s creditors but it can also put the business assets of an individual out of reach of individuals personal creditorsà by forming a company and putting assets in company in return for shares individual no longer has any legal interest in the assets
      • The partition of personal assets of the shareholder from his business assets:
        • If the shareholder is insolvent the personal creditors can take shares but not the assets of the company
        • Company can then give other creditors priority over the business assets
        • Can also partition its assets through subsidiaries in order to protect its assets
      • KEY: nexus of contract analysis insufficient to explain this key aspect of corporate behaviour à concession theory may gain weight since the state has a larger role in proprietary analysis
    • Armour and Whincop (2004) foundations of company law are proprietary in nature


Global Corporate Governance

  • Recent high-profile studies by La Porta et al (1998, 1999, 2003) – Forms of legal protection for shareholders are crucial in determining whether a market-based economy, in which the Berle and Means corporation plays a crucial role, will arise.
  • Context: global trend of promoting private law solutions that facilitate the emergence of a market-based economy
    • They argue that the level of legal protection for shareholders present in a jurisdiction is the key factor in determining corporate governance outcomes
      • They found after examining a wide range of countries that where there is weak investor protection public companies have concentrated ownership patterns
      • Conversely, where there is strong legal protection- the Berle and Means corporation with dispersed ownership characteristic will emerge which is more likely to facilitate private sector investment àweak investor protection has ‘adverse consequences for financial development and growth’
      • In 2003 they furthered this by claiming that state-based regulation of securities markets was ineffective
    • Criticisms of the La Porta thesis:
      • Simply incorrect- the authors have overstated the importance of minority protection in the emergence of foreign systems
      • Coffee (2001) suggested that La Porta et al have misunderstood their results- may actually have revealed that developed markets are a precondition for the emergence of strong shareholder protection (rather than the other way round)
        • Taking a contemporary sample of minority protection today could be misleading- this protection may have been introduced after the Berle and Means corporation emerged


The UK Corporate governance debate

The Berle and Means corporation (dispersed ownership system) emerged in the UK at a later stage than in the USA and the corporate governance debate has differed markedly

  • UK reaction to the underperformance of the 1970s differed from the US at first – a concern about unaccountable managers which led to underperformanceà focus on industrial democracy as a solution to this unaccountability
  • USA reaction sought solutions based on shareholder primacy whereas the UK sought to constrain management discretion by increasing the power and participation in the firm of the employees
    • Bullock Committee (1977) high point in industrial democracy debate- advocating a more inclusionary approach (more employee participation)
    • Margaret Thatcher’s administration 1979- looked up to the US free-market economicsà bitch reformed all of public sector to base upon market solutions
      • The privatisation of public sector industries (gas, water, electricity) BRITISH GAS- extortionist
      • Reform of pension provision, health care, social welfare, removal of employment protection, removal of barriers to capital inflow and outflows –changed the nature of the corporate governance debate COMPLETELY:
        • Industrial democracy was off the agenda and replaced by shareholder-oriented, market based solutions à a boom in late 80s then recession by early 90s
      • Management in the UK appeared to push higher proportions of wealth generated by the company to shareholders as dividends rather than reinvesting it in the company
        • Effect- companies appeared to be adopting a Jensen and Meckling (1976) model: where discretionary surplus cash flow is distributed immediately to the shareholders
        • Combined effect of these market based shareholder performance measures and employment reform: easy choice for management to cut costs by firing employeesà employee insecurity was rife + at time directors remunerations were insanely high + unexpected total collapse of some high-profile companies = corporate governance reform a political issue

UK Corporate Theory

Corporate theory in the 20th century dominated by US theorist. Corporate law as a separate area of study in the UK only emerged in the 1950s

  • Economic theory has not until very recently been a feature of the UK CG debate
  • Ireland (2003) captures majority view- arguments against the primacy UK company law gives to shareholders- 3 general points:
    • Corporations are very powerful and therefore have an enormous effect on society à a narrow accountability to shareholders is insufficient to protect society’s interests
    • Parkinson (1993) the assumption that shareholders have a moral claim to primacy by virtue of property rights is plainly incorrectà must justify on other grounds
    • The moral claims of stakeholders either outweigh the shareholders claims or at least equal to them in allocation of primacy
  • These moral claims overwhelmed by the efficiency-based arguments of government and private sector in the 1980s
    • By 1990s a twofold approach emerged in CG literature
      • Still morally right to include stakeholders in the decision making process
      • It could be justified on competitive grounds
    • Parkinson (1993) Corporate power and Responsibility Issues in the Theory of Company Law- shareholders have no moral entitlement to primacy in company law + builds the case for CSR à engages with the CONTRACTARIAN MODEL and wins
      • Much of post-1990 UK lit merely acknowledges economic theory before returning to more familiar territory

The Industry Response

  • A succession of scandals and recession in the late 80s and early 90s led to reform of UK listed companies
    • The collapse of 3 companies: BCCI, Polly Peck and the Robert Maxwell Group – all had clean audits but suddenly collapse denting market confidence in accountability of managers à a general public distrust of large companies

The industry itself co-ordinated response with the Bank of England, not the government with legislature

  • The Cadbury Committee (1992) established by the Financial Reporting council, and London stock Exchange, combined accounting bodies, chaired by Sir Adrian Cadbury
  • Examined boardroom accountability issues- produced solutions based upon the monitoring role of non-executives and wider disclosure regimes à Main recommendations:
    • Emphasized key role of the board in company decision makingand recommends that major transactions should be decided by the board ‘this may seem obvious but Cadbury was concerned that senior mangers rather than the board were making these key decisions with the resulting diminishing of board responsiblity’
    • Key roles of managing director (CEO) should not be combined with role of chairman of the Board- dangerous concentration of power, allows individual to dominate board
    • Main board should have non-executive directors (NEDs) sufficient in number and quality to carry significant weight in board decisions. These NEDs should be independent of the company. A committee structure should be put in place to improve the accountability of the appointment of directors, remuneration and the audit process
  • The majority of the Cadbury Committee recommendations were implemented by the LSE. BUT not implemented as enforceable Listing rules à by the odd mechanism of appending them to the Listing Rules
    • No penalty for non-compliance but if a company did not comply it had to explain why it had not complied
    • Left it to companies to decide themselves because no external scrutiny of the explanations for non-compliance à idea was tat shareholders would punish company by selling shares
  • The NED was the Cadbury solution to accountability issues in Listed companies- non-executives offered a way towards a more accountable management style
    • NED in essence a neo-classical ex ante monitor designed to ensure the efficiency of management
    • PRONED an experiment of in implementing NEDs successful in ways
  • Weaknesses- Cadbury left some key issues incomplete:
    • Never actually defined independence so companies continued to appoint friends of management, ex managers etc to board as NEDs (Nepotism)
    • Did not specify that NEDs be a majority on the main board and allowed executive managers to sit on the sub-boards making it difficult for NEDs to be effective à increasing of directors pay despite new mainly non-executive remuneration committee
  • The Greenburg Committee

By 1995 enormous public outcry at large director pay increases specifically for executives of the privatised utilities à industry response to set up committee headed this time by Sir Richard Greenbury to examine the issue of directors remuneration

  • The Greenburg committee (1995) report- Directors Remuneration, Report of the Study Group -identified the key issue of directors remunerations as the inherent conflict of interest in directors deciding on their own pay
  • Recommends the following:
    • There should be no executives on the remuneration committee because of their inherent conflict of interest
    • Share options should be replaced by long term performance related criteria which are put to the shareholders à impossible to tell how much they would be worth so need to get rid of them
    • Higher levels of salary disclosure in the annual accounts- to enable closer scrutiny of directors salaries
    • Directors should have one year rolling contracts so can be dismissed more easily without need to pay off remainder for long term contracts
  • The Hampel Committee

Cadbury committee had recommended a committee should be appointed to review effect of its recommendations and update them- a review of Cadbury and Greenburg- recommends:

  • Cadbury and Greenbury recommendations incorporated into a Combined Code
  • Non-executives should have a leader- creating three power bases on the board (managing director, chairman and leader of nonexecutives
  • Inst investors should consider voting at General Meetings
  • Remuneration details should be even clearer and should include hidden costs

Have things actually improved?

  • Fact that there were no post-Enron collapses in UK listed companies an indication that audit committees are doing job properly
  • Directors pay still a problem- salaries continued to increase since Greenbury
    • Government introduced the Direcvtors Remuneration Reporting Regulations 2002 (SI 2002 and CA 2006 s 420) – these require a directors salaries to be put to the shareholders for an advisory vote
      • Non-binding vote but strong signal to remuneration committee that something is up

The Government Response

Election of Labour Gov in 1997 brings massive change of attitude to industry regulating itself

  • The collapse of US company Enron 2001 caused the Gov to launch many initiatives
    • A conflict of interest in the audit process- auditors earning too much for non-audit workà a completely misleading picture of company’s financial position
      • Lord Wakeham a pillar of UK establish and Chairman of Press Complaints was a member of the Enron audit committeeà Gov quickly announced would review role of non-executives and create a company law bill
    • The White paper and corporate governance
      • 2002 Gov published White paper containing a draft Companies Bill based on recommendations of the CLRSG final report that are central to the corporate governance debate
      • Change in formulation of directors duties to include other constituencies if directors feel so inclined à the ‘enlightened shareholder value’ approach
      • The annual report from the directors should include a section on the impact of the company’s activities on stakeholders
    • Enlightened shareholder value
      • Schedule 1 para 2 of draft bill 2002 – codification of directors duties formulated around a primary focus on the shareholders BUT strange formulation requiring directors to take account of ‘material factors’ included stakeholders
      • This was fixed by the Companies Act 2006- no mention of ‘material factors’
        • Obligation now definied in s 172 of CA 2006

‘A director of a company must act in the way he considers would be most likely to promote the success of the company for the benefit of tis members as a whole, and in doing so have regard to’

  • It retains the primacy of shareholders while also compelling directors to consider the company’s stakeholders- ‘hard regard to’ means ‘think about’ not just about ticking boxes
  • In terms of enforcement- only shareholders have the ability to ensure directors are complying with the stakeholder provisions of s 172


The Business Review

The change in the formulation of the directors core duty was accompanied in the 2002 White paper by the introduction of an Operating and Financial Review (OFR) – to provide a reporting statement on the company’s activities AS it affects stakeholder constituencies

‘a reporting requirement in these terms would also be a major benefit for a wider cross-section of a company’s stakeholders’

  • Auditors’ role also to encompass the OFR
  • The companies Act 1985 (Operating and Financial Review and Directors Report) Regulations 2005 were approved by parliament- requires directors of companies on stock exchange to prepare an OFR for financial years after 1 April 2005
    • Directors required to provide a ‘balanced and comprehensive analysis consistent with the size and complexit of the business’

Extremely controversial à poorly managed process complicated further by the European Accounts Modernisation Directive (2003/51/EC) which requires a fair business review (FBR) to take place

The US Sarbanes-Oxley Act 2002

In response to Enron and Worldcom scandals- applies to all US and non-US companies that are required to file periodic reports with the US Securities and Exchange Commision (SEC)

  • much more extensive reporting requirements than the UK companies listed on any US stock exchange or with registered debt securities in the US
  • Also applies to UK subsidiaries of US companies + UK companies with 300 or more US shareholders
  • S 906: every periodic report containing financial statement must be accompanied by written statements by the company’s CEO and CFO certifying that the report fully complies with the requirements of the securities Exchange Act 1934
  • S 302: the CEO and CFO of a company that files reports under the SEA must certify that each annual and quarterly report – financial information must fairly present all material respects the financial condition, results of operations and cash flows of the company

Massive costs: est. $5m for small companies and $30 m a year for larger companiesà some UK/US listed companies delisting from the US

The Independent Review of Non-executive directors

In 2002 Enron demonstrated that the NED was an ineffective monitor of management à the DTI announced review of non-executives to improve ‘quality, independence and effectiveness of UK NEDs’

The Higgs review - Key recommendations

  • At least half the board excluding the chairman should be independent NEDs
  • Chairman has a crucial role in operation of boardà CEO and Chairman should not be combined +their individual responsibilities should be defined
  • Role of non-executive director should cover four areas
    • Strategy
    • Performance
    • Risk
    • People
  • Review set out the definition of independence- A NED is independent when the board determines that the director is independent in character and judgement – no relationship or circumstances which affect his judgement
    • Such relationships and circumstances arise where:
      • Is or had been employee of company
      • Has or had a business relationship with company
      • Is being paid by company other than a directors fee
      • Has family ties to the company or its employees
      • Holds cross-directorships or has significant links with other directors
    • Listed companies ot happy with conclusions of Higgs Review BUT its main recommendations were implemented by LSE through combined code
    • KEY: Fleshes out many gaps left by Cadbury report and its sucessors –
      • Detailed guidance on role of the NED
      • Number of independent NEDs on a main board
      • A good definition of independence


“The proposed takeover of Cadbury highlights the importance of UK takeover regulation”

Cadbury’s recent takeover by US giant Kraft Foods, gauges the current position of takeover regulation in the UK; it points to a lack of managerial-level protection available for hostile takeover targets and the effects this has on the market for corporate control. The impact of this position on financial and economic development[1] must be assessed in conjunction with the potential economic and social costs of such a system. It is also essential to juxtapose the UK regime against US takeover regulation to assess the importance of the shareholder-orientated model in promoting fairness and profitability in takeovers. Various prevalent hypotheses, criticisms and market studies provide empirical and theoretical evidence to suggest the precarious position of defensive tactics in takeover regulation and the need for stringent accountability controls on managers. These areas of contention must be explored in order to understand the importance of the UK regime in allowing hostile takeovers like Cadbury to prevail.

The UK has long had the most active takeover market in the European Community[2] and a widely respected “non-statutory” system, emphasizing self-regulation based on the cooperation of all major domestic financial and legal institutions. This informs the position of the Takeover Panel, which consists of members drawn from such organizations, given the authority to administer the City Code on Takeovers and Mergers 1968 and to exact sanctions without going through court.   With the Companies Act 2006 and its’ implementation of the EU’s Takeover Directive 2004/25/EC[3], the Panel has been put on statutory footing with rule-making powers[4] and sanctions[5] enforceable by court. This flexible administration of takeover rules allows for ‘real-time’ guidance; rules created due to efficacy which fit current market structures. Further, the limited use of the court suggests speedy results and smaller costs for companies engaging in takeover activities, making the domestic takeover market more accessible.

The City Code reflects the strong influence of institutional shareholder interests in the UK financial sector[6] which underlies its most fundamental principle; the equal treatment of shareholders. This is manifestly shown by the ‘mandatory bid’ rule which requires any person who acquires more than thirty percent of a target’s voting securities to make an offer for all of the voting shares of the target[7]. By forcing the bidder to buy up all shares at an equal price, all target shareholders will benefit from the premium for control. Further, the added provision restricting target directors from resigning[8] after selling shares to the bidder ensures that all subsequent buying of shares are fair, protecting minority shareholders once de facto control of the company by bidder is achieved. Partial bids; for more than fifty percent but less than all, are generally prohibited as they require consent of the Takeover Panel which they do not normally give[9], does away with the possible abuse inherent to the two-tier bid[10].  These rules which regulate the pricing and structure of a bid clearly points to a shareholder-orientated model where regulation favours the interests of security holders over managerial interests.

Moreover, the non-frustration rule[11] limits the ability of the target board to frustrate a bid by prohibiting the target board from issuing new shares, selling assets, or entering into contracts outside the ambit of daily operation without shareholder approval, when an offer is ‘imminent’. There is high incentive in the event of a hostile bid for target management to delay or render the takeover impossible; to entrench their position and to allow offer price to increase to ensure the best deal (i.e. entrenchment hypothesis, bargaining-strategy hypothesis). The Cadbury takeover was possible only because of such limitations on target management since it was clear from their position, during the initial offer until the completion of the takeover[12], that the Cadbury management was deeply opposed to the bid; “"There is no strategic, managerial, operational or financial merit in combining with Kraft - indeed we consider the reverse is true."-Roger Carr, Cadbury chairman pre-takeover[13]. This preclusion of defensive options available to target management ensures that the final decision to sell is left to the target shareholders based on value of offer alone.  These provisions which prohibit defensive tactics makes it easier for hostile bids to succeed in the UK[14]

The effect of hostile takeovers on the market for corporate control is a pivotal justification for the UK’s openness to such bids. The market for corporate control can be understood as a market in which alternative managerial teams compete for the rights to manage corporate resources[15]. The hostile takeover is a mechanism which enables managerial predation; the successful hostile bidder can replace incumbent managers, producing a disciplinary effect. It posits that inefficient management of corporate resources will be self-corrected by the market for corporate control, maximizing wealth creation. Further, the threat of takeover, works indirectly to deter incumbent managers from engaging in any activity which adversely impacts shareholder/investor interests, or from devaluing the company.  This view is succinctly expounded in John Coffee’s disciplinary hypothesis[16] which underlines that the role of the tender offer is to replace inefficient management.  It argues that the bidder pays a premium over current market price because it believes that the target’s assets are not optimally managed thus better management resulting from successful tender offer will create higher returns, justifying the premium.  In this sense, the hostile bid can be seen as a socially desirable phenomenon benefitting both the bidder and the target stockholders; both divide among themselves the value which incumbent management inefficiencies had denied them.

Similarly, the synergy hypothesis articulated by Gilson and Bubcheck[17] argues in favour of hostile takeovers. The distinction between the two theories is that the takeover premium is justified by the “synergistic gains” rather than the aforementioned sub-optimal performance in the disciplinary hypothesis. These are economic factors such as unique product complementarity, economies of scale and reduction of borrowing costs. Although there is little empirical evidence found from post takeover studies of company profits to suggest that synergy directly creates higher profits, both of these hypotheses postulate that takeovers are positively linked with wealth creation and both the bidder and target shareholders share the gains.

These positive views on the effects of hostile takeovers follow the current position of the UK regime, as highlighted by the Cadbury takeover in favouring of receptiveness to hostile bids. However, this begs the question; if hostile takeovers (tender offers) are generally beneficial to all parties then what justifies the practice of defensive tactics which serve to reduce such activity? This area of contention must be clarified by a comparison between the UK regime and US takeover regulation which permits the use of such tactics and directly limits receptiveness of tender offers.

In the US, hostile bids are regulated primarily by the Securities and Exchange Commission under the Williams Act amendments to the Securities and Exchange Act of 1934[18]. It contains offer timing provisions and disclosure rules but in stark contrast with the UK regime, does not contain a mandatory bid rule or prohibit partial/ two-tier bids, highlighting less emphasis on shareholder equality. The Delaware law allows managers much discretion in the event of hostile bids; an ‘auction rule’ which requires the board to maximize shareholder returns and the ‘just-say-no’ defense which obliges target board to provide a proposal which is in the best interest of the corporation without regard to maximizing short-term shareholder value[19]. Moreover, the Business Judgment Rule[20] adopted on the State level allows target directors to resist a hostile takeover where they are acting in good faith and has ‘reasonable grounds for believing that a danger to corporate policy and effectiveness existed’. This high level of managerial discretion in bid resisting shows a very different position in the United States; putting profit maximization and efficient business operation before the interests of security holders.

It follows from this managerial-orientated model that defensive tactics are within the ambit of policy objectives; to safeguard the managerial discretion which lies at the heart of company law. The most effective of the various defensive devices target management can employ is the poison pill[21] or shareholder rights plan which dilutes the stake of a hostile bidder, usually triggered effect after bidder acquires around 10 percent, by inviting all target shareholders to buy two shares for the price of one. Its effectiveness lies in its advantages over other defenses; it can be adopted by any company at any time without shareholder approval, it does not incur significant transaction costs, it does not affect the conduct of day-to-day business and it made a company ‘takeover-proof’[22] unless redeemed by the target board.

In the seminal US case of Paramount Communications, Inc v Time, Inc (“Time-Warner”)[23], Delaware Supreme Court allowed the board of Time, which was faced with a hostile tender offer from Paramount, to proceed with its own tender offer for Warner Brothers and retain its poison pill. It was held that an inadequate premium offer supported by the opinion of outside board directors and a fairness opinion (i.e. by its investment bank), is sufficient grounds for the target board to ‘just-say-no’ and retain its poison pill. An important consideration should be noted here; if Cadbury was a US registered company and Delaware law regulated the hostile tender offer of Kraft Foods, the board would likely have grounds for the ‘just-say-no’ defense after the initial offer. Kraft offered 300p in cash and 0.2589 new Kraft shares for each Cadbury share, which the target board rejected and described as “derisory”[24].

Other defensive tactics are also available to target management but are generally less effective than the poison pill. The ‘white knight’ tactic seen in Revlon, Inc v MacAndrews & Forbes Holdings, Inc[25] allows for the target board to find a friendly acquirer to counter a disfavoured bid. The ‘shark repellant’, ‘greenmail’ and ‘pac-man’ defenses increases the defensive arsenal available to target management. It posits that such a high level of managerial discretion reduces the effectiveness of the hostile takeover mechanism in the market for corporate control and allows for the entrenchment of managerial positions.

Furthermore, this position allows for the Empire Building Hypothesis which argues that management pursues size for greater compensation and greater security from future takeovers. This is a negative view on the effects of hostile takeovers; that target managers engage in such activity only to increase the size of their own remuneration and to entrench their position for self-interest reasons thus allowing for security holder interests to be ignored. Additionally, because the US system allows for two tier bids, it also allows for the Exploitation thesis where a two tier bid is sold at different prices (i.e. the mandatory bid rule in the City Code prevents this from occurring in the UK); the first 51 percent at a high premium but the rest of shares at a much lower price. By exploiting temporary depression in the targets shares, returns are much higher for the bidder. Both these viewpoints suggest that the US system is more susceptible to the negative impacts of tender offers, however, they can also be seen as wealth transfer; Empire building benefits the target and Exploitation benefits the bidder.

As our analysis stands, the takeover of Cadbury highlights the different modes of takeover regulation in its openness to hostile takeovers and the diverse implications this has on shareholder and managerial interests. Further review of empirical and theoretical evidence will clarify the impact of these findings. The studies conducted by Easterbrook and Fischel (1993) showed a 10 percent increase in share value following successful hostile takeovers where there was no poison pill adopted, suggesting that allowing takeovers increases shareholder wealth[26]. This is corroborated by Jensen and Ruback (1983) who found corporate takeovers generate positive gains, that target shareholders benefit and that the bidding firm shareholders do not lose out[27].   However, an opposing view is found in Deakin and Singh’s The Stock Market, the Market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy. They argue that “contrary to current conventional wisdom, support for an active market for corporate control is neither a core principle of company law nor an essential ingredient of financial and economic development”[28], pointing at the absence of such a market in countries such as Germany and Japan as a positive institutional arrangement and not a deficit.

Their view that regulatory changes are currently being encouraged is illustrated by the Winter Report (2002) which was conducted following the failure of the EC Commission’s proposal to be approved by a majority of the Parliament and found that no level playing field existed for takeover bids in the Community[29].  This report finds from empirical evidence that takeover bids are basically beneficial, that the market for corporate control is in the long term in the best interests of all stakeholders and society at large. These views form the basis for the directive[30] , which are much similar to those justifying the City Code, will further the development of the takeover market in the EC

In conclusion, the position of the UK takeover regime is both highlighted and defined by the analysis that follows the issues raised by the Cadbury takeover. The receptiveness of the takeover market to hostile bids in the UK allowed for such a bid to succeed and many of the hypotheses and market studies discussed above consolidate this finding. However, the comparison between the UK and US models of takeover regulation shows an alternate standpoint which is equally valid. The sanctioned practice of defensive tactics although bears disadvantages to stockholders, allows for the managerial discretion which is fundamental for effective business operation. Finally, the disciplinary mechanism of hostile takeovers on the market for corporate control serves an invaluable role in limiting entrenchment and exploitation of stockholders and suggests the prevalent direction of takeover regulation development in relevant market towards increasing receptiveness to hostile offers.