Promoting corporate success

Coming into force this coming October, the new statutory statement of directors’ duties is generally considered to be one of the more controversial aspects of the long-awaited UK Companies Act 2006.
Notably, the legislation presents new challenges for those directors operating in the private equity field: first when private equity houses approach existing public companies regarding a takeover bid; and secondly, once a company has gone private and a newly constituted board takes over.
On October 1, 2007, the existing common law fiduciary duty on directors to act “in the best interests of the Company” will be replaced by a new codified but subtly different version of this requirement.
The new version appears in section 172 of the Companies Act 2006.
In the midst of widespread censure of private equity firms, it is interesting to consider what, if any, impact this newly worded duty will have on the target board both before and after a successful bid.
While, justification and/or defense of the private equity sector are beyond the scope of this article, it is useful to consider some of the criticisms made as follows. Private equity firms have been accused of:
Asset stripping – selling assets and releasing finance
Reducing employees as overheads – cutting jobs at every opportunity without reference to longer term needs and lost skills base
Having less transparent costs of capital – a complex mix of private equity, mezzanine and convertible debt financing instruments in place of public equity
Short termism – engineering share price gains by selling assets and releasing finance
Being the unaccountable face of capitalism – companies taken private do not have the same level of public scrutiny from the investment markets. Investors will have more information than is ever available in the public sector; other stakeholders will generally have less information.

Enlightened shareholder value
Let’s first take a look at the differences between the old law and the new.
The first difference between the old common law and the new codified law is the language. Instead of “acting in the best interests of the company” the directors will be required to “promote” its “success.”
We do not believe there is any real difference in meaning between “acting in the best interests of the company” and “promoting the success of the company.” Rather we see this as just another example of the UK Government using the Companies Act 2006 to update archaic language to make it more “understandable” and “modern.”
The Government has however indicated that for this purpose, “success” will usually mean “a long-term increase in value.”
The second difference is that in “promoting the success of the company,” there is an explicit requirement to consider (“amongst other matters”) a wide range of, at times, competing interests including those of employees, the environment, the community, good relations with suppliers and customers; and the need to maintain high standards of business conduct and to act fairly as between shareholders (the “Factors”). The list is not exhaustive but highlights areas of particular importance which reflect the wider expectations of responsible business behavior. It is by this means that the new concept of “Enlightened Shareholder Value” has been introduced.
Enlightened Shareholder Value represents the middle ground which emerged from the (at times heated) debate that preceded the enactment of this new law. The debate concerned whether directors should have a direct duty to stakeholders or whether they should continue as under existing common law only to have a direct duty to shareholders. The idea of Enlightened Shareholder Value, as set out in new section 172, is that the overriding duty to “the shareholders as a whole” (“to promote the success of the company”) continues but this is now coupled with an acknowledgement that, in order to do so, you have to consider (“amongst other matters”) the Factors.
One consistent element between the old and the new law is that the test for compliance is not objective but rather, one of the directors’ “good faith” view. But there remains the interesting question of whether or not the “good faith test” has been modified by the new requirement to have regard to the Factors. It would seem that it is no longer sufficient that the directors act in good faith alone.
They must also have regard to the Factors and there has to be some level of demonstrable objective evaluation.
All of this leads to the question of what will happen if directors do not have regard to (or have inadequate regard) to the Factors. Will that be sufficient for them to have breached their duty? This goes to the root of the uncertainty surrounding the new duty. Faced with this uncertainty, the cautious approach will be to assume the answer is “yes.” This leads to two further questions:
– How will sufficient regard be measured and/or proved?
– What will be the consequences of breach?
There is also the separate question of conflict between the Factors.
It’s our view that, if having had regard to all Factors, the directors make their decision as to what will “promote the success of the company,” there are no grounds for concern here. This is not a question of preferring Factors, but weighing up the advantages and disadvantages for the company, having looked at the impact of each Factor.

Consequences of breach of Section 172
As is the case now and will continue to be the case beyond October, the only right of action for a breach of this duty lies with the company itself either directly or indirectly by means of a derivative claim. It is clear to all that, if and so long as the culprits control the board, no such direct action will ever be brought. This effective stalemate has given rise to the common law derivative claims procedure.
The procedure allows shareholders, in certain circumstances, to bring a claim on the company’s behalf. However the common law procedure is generally recognized to be chaotic, inexplicable, illogical and ineffectual.
For these reasons the derivative claims procedure was high on the list of common law principles to be codified and redressed by the new Companies Act. Thus, once again, this is not pure codification. One of the deliberate changes is that the circumstances in which it will be possible to bring a derivative action are wider than before. Thus, if the legislation works as intended it should make it easier for shareholders to bring derivative claims.
As a result there has been much concern that shareholders will bring vexatious derivative claims against directors for having breached their section 172 duty by failing to have had regard to some or all of the Factors.

Sufficiency and evidence – more paper trails?
If you read the Government’s explanatory notes on section 172, you learn that lip service is not enough. Action may be required. But not more than good faith and reasonable care, skill and diligence would be required. Procedural
failures will not of themselves be indicative of breach.
Margaret Hodge, the Minister of State for Trade and Industry has said: “The Bill does not require directors to keep additional records but simply to have due regard to these wider factors, with the weight being given to any factor, being a matter of their good faith business judgment.”
It’s not surprising that the question on the lips of all directors’ is: where does this leave us?
As things stand, if one or more directors are accused of breaching their current common law duty they may need to prove evidence of their good-faith view that they acted in the company’s best interests. In respect of decisions taken after October 1, 2007, they will, in addition, need to prove that they had regard to the Factors. We therefore expect some changes in board and committee processes. The key thing will be to address this in a proportionate way. Some decisions will be bigger and more proportionate than others.
In those instances it may be appropriate to commission one or more expert reports so that proper regard can be given (and be seen to have been given) to relevant Factors.
One final thing to bear in mind is that the common law switch in looking towards the interests of creditors at the point at which the company becomes insolvent and potentially unable to continue is retained.
The Government has not tried to codify that particular duty, and we still go back to the common law at that stage.
We expect to see advice being given to directors that, whilst the actual decision is based on subjective good-faith assessment, there will be an expectation that the underlying data and factors will be recorded to evidence the objectivity of the review process.
Clearly, it is easy to blur the distinction between the express duty “to promote the success of the company” and the need to weight the Factors to which the directors must have “regard.” Thus, although it will be up to the directors, in good faith, to decide what weight is to be given to each competing Factor, the decider will always be whether the directors consider that the bid will promote success and result in “a long-term increase in value.” In the case of the recent private equity approach to Sainsbury’s, Lord Sainsbury explained why he thought the bid would not lead to “a long-term increase in value” when he said (as quoted in the press): “Sainsbury’s success has been based on a strong balance sheet and a largely freehold property base. Eroding these attributes will make the company more vulnerable to competitive pressures, which is not in the best long-term interests of the company, its customers, its staff, its shareholders or its pensioners.”
Lord Sainsbury may not now be speaking as a director, but this does look to be the approach that Margaret Hodge has in mind under the new legislation.

Rebecca Hunter also contributed to this article