ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
74 © Emile Woolf Publishing Limited
Directors and the law
The powers and rights of directors
Appointment, election and removal of directors
Duties and legal obligations of directors
Share dealings by directors
Disqualification of directors
Changing directors
4 Directors and the law
Corporate law varies between countries. However in all countries, directors act
within a legal and regulatory framework. They have certain rights as directors, but
also certain duties and responsibilities. If they fail to carry out their duties or
responsibilities properly, they could become personally liable for their failure.
Various aspects of company law are described in this section. In different ways,
each aspect of the law has implications for corporate governance.
4.1 The powers and rights of directors
The powers of the company are given to the board of directors as a whole, although
many of these powers are delegated to executive management. Individual directors
should normally have the authority to enter into contracts in the company’s name.
In UK law, individual company directors have an implied power to make legally-
binding contracts for the company, even if they have not been given the specific
actual authority to do so.
Service contracts
Executive directors are full-time employees of the company. As employees, they
have a service contract with the company. A service contract for an executive
director is a legally-binding contract of employment. A service contract includes
terms such as entitlement to remuneration including pension rights, and a
minimum notice period for termination of office.
An executive director, like any other employee of the company, should be protected
by the same legal rights that are given to all employees by the employment law of
the country.
The service contract of an executive director should specify his role as an executive
manager of the company, but might not include any reference to his role as a
company director. However, if he is subsequently asked to resign from the board, it
is generally-accepted practice that the company is also dismissing him as an
executive manager. The director then has all the rights given to him in his service
contract in the event of dismissal, as well as rights provided by law relating to
unfair or wrongful dismissal by the company.
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Fixed-term contracts
Non-executive directors are usually appointed for a fixed term. In the UK, normal
practice is to appoint an NED for a three-year term. At the end of this term, the
appointment might be renewed (subject to shareholder approval) for a further three
years. This cycle of three-year appointments continues until the NED eventually
retires or is asked to retire.
4.2 Appointment, election and removal of directors
An aspect of corporate governance is the power of the shareholders to appoint
directors and remove them from office. Practice in the UK is fairly typical of other
countries.
When a vacancy occurs in the board of directors during the course of a year, the
vacancy is filled by an individual who is nominated and then appointed by the
board of directors.
However, at the next meeting of the company’s shareholders (the next annual
general meeting), the director stands for election. In the UK, the director is
proposed for election, and is elected if he or she obtains a simple majority (over
50%) of the votes of the shareholders.
Existing directors are required to stand for re-election at regular intervals. In the
UK, most companies include in their constitution (articles of association) a
requirement that one-third of directors should retire each year by rotation and
stand for re-election. This means that each director stands for re-election every
three years. (This is why appointments of NEDs are for periods of three years.)
It is usual for directors who retire by rotation and stand for re-election to be re-
elected by a very large majority. However, when shareholders are concerned
about the corporate governance of a company, or about its financial
performance, there might be a substantial vote against the re-election of
particular directors.
When a director performs badly, it should be expected that he or she will be
asked by the board or the company chairman to resign. This is the most common
method by which directors who have ‘failed’ are removed from office.
Occasionally, a director might have the support of the board, when the
shareholders want to get rid of him. UK company law allows shareholders (with
at least a specified minimum holding of shares in the company) to call a meeting
of the company to vote on a proposal to remove the director. A director can be
removed by a simple majority vote of the shareholders.
When a director is removed from office, he retains his contractual rights, as
specified in his contract of employment. This could involve a very large payment.
4.3 Duties and legal obligations of directors
Directors have certain legal duties to their company. If they fail in these duties, they
could become personally liable for the consequences of their breach of duty.
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In the UK, the Companies Act 2006 introduced statutory duties for directors. These
are duties to:
act within their powers
promote the success of the company for the benefit of its shareholders
exercise independent judgement
exercise reasonable skill, care and diligence
avoid conflicts of interest
not to accept benefits from a third party
declare any interest in a proposed transaction with the company.
Prior to the Companies Act 2006, the legal duties of UK company directors to their
company have been:
a duty of skill and care
a ‘fiduciary duty’: this is a duty to act in the utmost good faith in the interests of
the company.
Two examples of a breach of fiduciary duty are putting personal interests ahead of
the interests of the company (when there is a conflict of interest) and failure to
disclose a personal interest in a contract with the company. Both of these breaches of
duty are agency problems, identified in agency theory.
Conflicts of interest
A director would be in breach of his fiduciary duty to the company, for example, if
he puts his own interests first, ahead of the interests of the company.
One example from UK law is the case of an individual who was the managing
director of a company that provided consultancy services. One client decided that it
would not use the company for planned consultancy services, but indicated that if
the managing director applied for the contract personally, it might be willing to give
the consultancy work to him. The managing director informed his fellow directors
that he was ill, and persuaded the company to release him from his contract of
employment. On ceasing to be a director of the company, he applied for the
consultancy work with the client, and was given the work. His former company
successfully sued him to recover the profits from the contract.
The court decided that the former managing director was in breach of his fiduciary
duty to the company, because he had put his own interests first, ahead of the
interests of the company in obtaining the contract work for himself.
Disclosure of interests
A breach of fiduciary duty would also occur if a director has an interest in a
contract with the company but fails to disclose this interest to the rest of the board
and obtain their approval.
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Typically, a company director might be a major shareholder in another company
which is about to enter into a supply contract with the company. When this
situation occurs, the director must disclose his interest as soon as possible to the rest
of the board, and obtain their approval. Failure to disclose the interest would make
the director liable to hand over to the company all his secret profits from the
contract.
In the UK, it is also a criminal offence for a director to fail to disclose an interest, and
the punishment for a breach of this law is a fine.
4.4 Share dealings by directors
It is common for directors of stock market companies to own some shares in their
company.
Because they work inside the company, directors will occasionally obtain
information about the company (or another company) that:
has not yet been made public, and is still confidential, and
when it is eventually made public, it is likely to have a significant effect on the
price of the company’s shares (or the price of the other company’s shares).
An example is obtaining information about a planned takeover bid involving the
company. When one company wants to take over another, it will make a private
approach to the board of the other company, indicating its wish to buy the shares in
that company. If the board of the target company is willing to negotiate terms, there
is a period during which secret discussions take place. Inevitably, the directors of
both companies will be aware of the discussions. During this period, the
information about the probable takeover bid remains confidential, but when the
information becomes public (after the terms of the takeover are agreed and
announced to the stock market) the share price of the target company normally rises
substantially, up to the price of the takeover bid.
It should be apparent that a director could use the confidential price-sensitive
information about the takeover bid to buy shares in the target company, before the
takeover is announced. By purchasing the shares, the director would expect to make
a substantial profit by selling the shares in the takeover. The profit of the director,
however, would be obtained at the expense of the shareholder who sold him the
shares.
Taking advantage of price-sensitive information about a company to buy or sell
shares, or to encourage anyone else to buy or sell shares, is a criminal offence,
known as insider dealing.
When an individual such as a director is found to have carried out insider dealing
(or insider trading):
he might be found to have committed a criminal offence, and face a fine and
imprisonment, and/or
he might be found liable in civil law to the individuals at whose expense he
made his profit.
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Example
At the end of its financial year, a major stock market company (not named here)
found that its profits would be much lower than stock market investors were
expecting. In addition, it was probable that news of an anti-competitive arrangement
with a major supplier might be made public in the near future.
Most of the directors and many senior executives in the company sold substantial
quantities of shares in the company that they owned, before these items of news
were released to the stock market. In doing so, they avoided losses that they would
otherwise have suffered; when the information was released to the public, the
company’s share price fell.
The directors and senior managers of the company made themselves liable to a
charge of insider dealing, avoiding losses at the expense of the investors who
bought their shares. In addition, the directors who sold their shares in the company
were in breach of their fiduciary duty, because they put their interests first, ahead of
the interests of the other shareholders.
Stock market restrictions on share dealings by directors
Insider dealing is an offence. However, directors of a company will often be in a
position to judge how well or badly the company is performing when other
investors are not in a position to make the same judgement. If they buy or sell
shares in their company, they might be suspected of insider dealing and putting
their own interests first.
In the UK, the law on insider dealing has been supplemented by a code of conduct
for directors and other senior employees of listed companies. This code is known as
the Model Code. All listed companies are required to apply this code of conduct, or
a code that is no less strict.
Applying the Model Code will help to maintain investor confidence in the activities
of company directors. The main requirements of the Model Code are as follows.
Directors must not deal in shares of their company during a ‘close period’. A
close period is the period before the announcement to the stock market of the
company’s interim and final financial results.
A director must not deal in shares of the company at any time that he has price-
sensitive information.
Before dealing in the company’s shares at any other time, a director must obtain
the prior permission of the chairman.
4.5 Disqualification of directors
The corporate law of a country might provide for the disqualification of any
individual from acting as a director of any company, where the individual is guilty
of behaviour that is totally unacceptable from a director.
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To some extent, laws on the disqualification of directors might possibly provide
some protection to the shareholders of a company. However, disqualification only
occurs after the unacceptable behaviour has occurred.
In the UK, for example, the law allows a court to disqualify an individual from
acting as a director of any company in a variety of circumstances. These include:
when a director is bankrupt
when a director is suffering from a mental disorder
when a director has been found guilty of a crime in connection with the
formation or management of a company (such as the misappropriation of
company funds).
However, the disqualification of an individual from acting as a director is more
likely after a company has become insolvent, rather than whilst the company is still
operational and solvent.
4.6 Changing directors
Directors should not expect to serve as directors of the same company for ever. In a
well-governed company, there should be a process or ‘renewal’ over time with new
directors coming on to the board to bring a fresh outlook and other directors
leaving.
A system of good governance should provide for changes to the membership of a
board of directors over time.
On some occasions, a director may retire voluntarily. He can do so at any time. His
reasons for retiring may be to take a job somewhere else, or because he has reached
retirement age, or simply because he does not want to serve as a director any more.
A company may have a requirement in its constitution for directors to retire by
rotation, typically every three years. The UK Combined Code also states that
directors should retire by rotation at least every three years. Directors retiring by
rotation do so at the company’s Annual General Meeting.
When a director retires by rotation, he or she can stand again for re-election at
the AGM. To get re-elected, they need votes if favour from a majority of the
shareholders.
In theory this means that shareholders get an opportunity to remove any
director they do not like, but only in a year when the director retires by rotation
and stands for re-election. For example the shareholders may try to prevent the
re-election of the chairman of the remuneration committee (or any other member
of the remuneration committee) if they think that remuneration for senior
executives is too generous.
In practice, it is difficult for ‘dissident’ shareholders in a large company to obtain
a majority of votes to prevent the re-election of a director, if they are voting
against the wishes of the rest of the board.
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Changes in a board of directors are often decided by a majority of the board itself.
The board may decide that the contract of a non-executive director should not be
renewed. Contracts for NEDs are usually for a three-year period, and if the
board decides that it wants to let a NED go (perhaps in order to recruit a new
person to the board), it can simply tell the outgoing NED that his contract will
not be renewed for a further three years.
The board may decide that it will not recommend the re-election of a director,
who stands for re-election against its wishes. Shareholders are normally unlikely
to re-elect a director who does not have the support of his board colleagues.
When a director is performing badly in his job, the rest of the board may decide
that he must be forced to resign. The director is informed that he has lost the
confidence of his board colleagues, and must go. On leaving the board, the
individual may also be required to resign from his job, if he is an executive
director. When this happens he negotiates compensation for loss of office. (There
have been many cases where a CEO has been ‘sacked’ from the board and has
received very high compensation, seen as a ‘reward for failure’. A notable
example in the UK was the money paid to Sir Fred Goodwin, CEO of the Royal
Bank of Scotland, when he was forced out of the company after its collapse in
2009 and the UK government took a majority shareholding.)
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Induction, training and performance evaluation of directors
Induction for new directors
Training and professional development for directors
Performance evaluation
Assessments of performance
5 Induction, training and performance evaluation of
directors
5.1 Induction for new directors
Induction is a form of training. In a company, its purpose is to make a new person
familiar with what the company does, how it operates, how it is organised, who the
senior managers are and so on. New non-executive directors need induction
training so that they can learn much more about the company that they are now
helping to govern. Unless they know about the company in some detail, their views
and opinions might be misinformed.
Executive managers who are appointed to a board of directors for the first time
might also need induction training, to improve their familiarity with aspects of the
company that they do not know much about. Executive managers should know
more about the company than new non-executive directors, but this does not mean
that they know everything that they should know about the company.
The UK Combined Code recognises the importance of induction, and states:
‘All directors should receive induction on joining the board’, and
‘The chairman should ensure that new directors receive a full, formal and
tailored induction on joining the board.’ The company secretary should assist the
chairman in ensuring that suitable induction is provided.
Induction to gain familiarity with the company
The Higgs Guidance suggests that the purpose of induction should be to help the
new director to:
develop an understanding of the company, its business and the markets in
which it operates
get to know the people who work for the company
develop an understanding of the company’s main relationships, for example
with key suppliers or customers.
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An induction programme might therefore include:
visits to important sites/locations where the company carries out its operations
demonstrations of the company’s products
meetings with senior managers and staff
possibly, meetings with professional advisers of the company
possibly, meetings with major shareholders (but only if the shareholder wishes
to meet the new director).
Induction to gain familiarity with being a director of the company
Another aspect of induction is helping a new director to become familiar with the
duties of being a director in the company. This can be particularly important for
individuals who have never been a company director before.
A new director should be given:
information about the matters that are reserved for the board (what the board
does)
guidance on the rules on share dealings by directors (including the law on
insider dealing)
copies of the minutes of recent board meetings
a schedule of dates for future board meetings
details of the committees of the board, and their responsibilities.
5.2 Training and professional development for directors
The UK Combined Code also states that:
‘All directors should ... regularly update and refresh their skills and knowledge,’
and
‘The chairman should ensure that directors regularly update their skills and the
knowledge and familiarity required to fulfil their role…. The company should
provide the necessary resources for developing and updating its directors’
knowledge and capabilities.’
The exact nature of the training and professional development that should be
provided will vary with the company and the requirements of the individual
director.
Deciding on the training or development that a director should receive might be
discussed each year, as a part of the performance review of the director.
Subject areas for training and development might include formal training in
business strategy, corporate governance issues or developments in financial
reporting. Directors should also be given demonstrations of new products, services
or processes that the company has developed.
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The Higgs Report on non-executive directors (2003), commenting on development
and training, stated that non-executive directors, on appointment, will already have
some relevant knowledge, skills, abilities and experience. However, the non-
executive director’s effectiveness on the board will depend on far more than their
existing skills; they need to have the ability to extend their skills further and refresh
their knowledge. They therefore need to take some sort of ‘training’ – not formal,
classroom training, but continued professional development tailored to the
individual.
5.3 Performance evaluation
The board is expected to perform a particular role for the company. Effective
corporate governance depends on having an effective board. It would therefore be
appropriate to carry out regular reviews, to asses how well the board has
performed.
The board is accountable to the shareholders, and it might therefore be argued that
the performance of the board should be judged by the shareholders. However, in
practice this would be difficult to achieve.
In some countries, codes of corporate governance include a requirement that the
performance of the board and its individual directors should be reviewed regularly,
and the review should be carried out by the board itself. The chairman should have
the responsibility for the performance evaluation.
The purpose of the performance review should be to ensure that:
the board is fulfilling its role and carrying out its responsibilities effectively
the board committees are also fulfilling their roles effectively
individual directors are contributing effectively to the work of the board and its
committees
the collective skills and experience of the board members remain appropriate for
the needs of the company.
UK Combined Code on performance evaluation
The UK Combined Code states that the board should undertake a formal and
rigorous annual evaluation of its own performance, the performance of the board
committees, and the performance of each individual director.
The Code includes the following provision: ‘Individual evaluation should aim to
show whether each director continues to contribute effectively and demonstrate
commitment to the role (including commitment of time…). The chairman should act
on the results of the performance evaluation by recognising the strengths and
weaknesses of the board and, where appropriate, proposing new members be
appointed to the board or seeking the resignation of directors.’
The performance review of the chairman should be carried out by the NEDs, under
the leadership of the senior independent director.