Scottish Law Commission (Discussion Papers)

Part 2 Guiding Principles for Reform

Introduction

2.1      In this part we aim to deduce the general principles which should guide the reform of the law in this area and to obtain consultees' views on them. Formulation of these principles involves standing back from the detail and complexity of the provisions of Part X, and the problems which they seek to address, and asking in somewhat abstract terms what policy approach the law should seek to adopt. This in turn requires an understanding of the role of the legal system in regulating directors, and of the contribution which the different organs within the company can make to the successful management of the company's business, and how this is best achieved. We seek consultees' views as to whether we have identified what they see as the right objectives to guide reform in this area.
2.2      This is not an academic exercise. The announcement of the DTI's Company Law Review means that there is both an opportunity to consider the contribution which each part of the Companies Acts makes to the whole and in addition a need to ensure that the policy basis for reform in any given area is properly understood. The reform suggested for any particular area of company law must blend in with the reforms being suggested for company law as a whole. The Law Commissions are placed in the difficult and challenging position of issuing the first consultation paper during the currency of this review. We hope that the exposition of the issues in this paper will assist in stimulating an open debate on the optimal shape of our company law for the foreseeable future.

Aims of company law reform

DTI's Company Law Review

2.3      We have already referred to this Review in Part 1. The DTI's Consultative Paper describes the Department's objectives in undertaking the review. They are:^[1]

to promote a framework for the formation and constitution of British businesses which through an effective combination of law and non-statutory regulation:

supports the creation, growth and competitiveness of British companies and partnerships;

promotes an internationally competitive framework for business, so that the UK continues to be an attractive place to do business;

provides straightforward, cost-effective and fair regulation which balances the interests of business with those of shareholders, creditors and others; and

promotes consistency, predictability and transparency and underpins high standards of company behaviour and corporate governance.

2.4      The DTI proposes that the terms of reference for the review should include the following:

(1) To consider how far core company law can be modernised in order to provide a simple, efficient and cost-effective framework for carrying out business activity which:

(a) permits the maximum amount of freedom and flexibility to those organising and directing the enterprise;

(b) at the same time protects, through regulation where necessary, the interests of those involved with the enterprise, including shareholders, creditors and employees; and

(c) is drafted in clear, concise and unambiguous language which can be readily understood by those involved in business enterprise.^[2]

2.5      The review is to be conducted with openness and independence and on the basis of wide consultation.^[3] The final report is to be published in the year 2000.^[4] The consultative paper states that the Government also intends to publish a white paper in the year 2000 outlining the Government's proposals for legislation in the light of the outcome of the review.^[5]

The Australian Corporations Law and Economic Reform Programme (CLERP)

2.6      In March 1997 the Australian Government announced a sweeping program of company law reform called the Corporations Law and Economic Reform Programme (CLERP) as part of the Government's drive to promote business and economic development. The intention is to provide a much stronger economic focus. The current law is deemed too prescriptive, legalistic and in many respects out of touch with modern commercial practice.^[6] There was previously a plan to re-write the Corporations Law in more understandable English. It has been decided that this alone is inadequate to address underlying problems, though a second Corporate Law Simplification Bill will nonetheless be introduced into the Australian Parliament. The Australian Treasury is committed to providing substantial resources to statutory agencies to enforce corporate law. As part of CLERP, draft bills were published on 8 April 1998 dealing with capital raising, takeovers, futures and securities, directors' duties, electronic commerce and accounting standards.

Recent Company Law Reform initiatives in Canada, New Zealand and Hong Kong

2.7      There have been a number of company law reform initiatives in the Commonwealth in the past twenty years. Prior to then most company law in the Commonwealth was based on the UK Companies Acts. We mention three of these initiatives.

Canada

2.8      In 1971 the Dickerson Committee published its report, "Proposals for a New Business Corporations Law for Canada" ("the Dickerson Report"). The report contained the draft for a new federal corporations Act that drew on both American and Commonwealth precedent. Following its publication, in 1975 a new federal corporate law statute was implemented that adopted the Dickerson Committee's draft virtually unchanged. Harmonising legislation was subsequently introduced in the majority of Canada's provinces.^[7] Extracts from the federal Canadian Business Corporations Act ("CBCA") appear in Appendix J to this paper.

New Zealand

2.9      In 1989, the New Zealand Law Commission published its 9th Report,^[8] "Company Law - Reform and Restatement".^[9] The report proposed a basic law to govern the creation, operation and termination of all companies and contained a recommended draft Companies Act. The Commission produced a supplementary report in 1990, "Company Law Reform: Transition and Revision",^[10] which contained recommendations for a variety of improvements to its 1989 draft Companies Act. The report also contained recommendations for and drafts of transitional and consequential legislation so that comprehensive company law reform could be implemented.^[11] Although its revised draft was not based on any one overseas model, the Commission acknowledged the assistance it had derived from the (US) Model Business Corporations Act and the Dickerson Report.^[12]
2.10      Following the Commission's reports, New Zealand enacted the Companies Act 1993.^[13] The Law Commission's draft was used as a basis for the new Act, although significant changes were introduced. Extracts from the Companies Act 1993 appear in Appendix I to this paper.

Hong Kong

2.11      When Hong Kong was a British colony the Companies Ordinance was adopted and it was based upon UK companies legislation. The ordinance continues to apply, but in 1994 the Hong Kong Government initiated a review of the ordinance. In the course of the review a consultancy report was prepared and published recommending widescale changes ("the Hong Kong Consultancy Report"). The Government of Hong Kong has yet to respond to this report. A combination of factors prompted a review of the ordinance. The last review of the Companies Ordinance had been commenced 25 years ago. Concerns were expressed about the redomiciling/overseas domicile phenomenon of listed companies and the Companies Registry had raised a number of practical problems with regard to the enforcement of the ordinance. Also changes to the UK legislation resulting from harmonisation with European Union Company Law Directives raised the issue of the continued suitability of the United Kingdom as a model for Hong Kong Companies law. The recommendations in the report are based on modern companies legislation in the United States, Canada and New Zealand. Extracts from the Hong Kong Consultancy Report appear in Appendix L to this paper.

Role of shareholders and directors in companies

2.12      Shareholders are owners of the enterprise: the directors manage it and control day-to-day decision-making.^[14] Directors have to have regard to shareholders' interests and to a certain extent^[15] to those of third parties. However, directors and shareholders are mutually interdependent. Directors rely on shareholders to maintain their investment in the company and exercise their powers in respect of decision-making reserved to them in a favourable manner. Shareholders rely on directors to manage the enterprise competently, without taking personal benefits, loyally and on the basis that so far as practicable shareholders are kept in the picture about any matter which is relevant to them.

Function of Part X and directors' duties

2.13      The provisions of Part X and (in some respects) the rules relating to directors' basic duties under the general law are designed to ensure that directors do not act in a way which confers an unacceptable benefit on them or persons who are close to them. The provisions of Part X are essentially a series of prescriptive rules: it epitomises the movement in UK company law since 1862 from what was originally conceived of as an enabling statute to a regulatory one with the tendencies of what is sometimes called "Christmas tree legislation".^[16] To achieve its purpose, Part X employs a number of techniques including absolute prohibition,^[17] a requirement for disclosure of interests to the board,^[18] a requirement for prior disclosure to all members whether they have voting rights or not,^[19] a requirement for prior disclosure to and approval by the company in general meeting, a requirement for disclosure to the Stock Exchange,^[20] disclosure by maintenance of a register which is open to inspection and disclosure in the annual accounts. A relevant question is always going to be whether the right technique has in fact been employed, and indeed whether there are other appropriate techniques not yet used in Part X.

What are the general principles that should guide reform of the law in the area of Part X and directors' duties?

Law Commission Report on Shareholder Remedies

2.14      As already explained, the Law Commission produced a report on this topic, in consultation with the Scottish Law Commission, in October 1997. The approach which we adopt in this part builds on the approach that the Commissions adopted in that report. In it the Commissions identified a number of guiding principles for the purposes of that reform exercise. We thus start by considering whether any of those principles is also relevant here: there is a very clear relationship between shareholder remedies, which are the means by which the aid of the court is invoked, and the present field of law which regulates the duties which directors owe to their companies and the terms on which they will be allowed to enter transactions which affect the company or its shareholders. So far as possible the principles underlying reform in both areas should be homogenous and harmonious. Indeed, as we have indicated above,^[21] there should in general be consistency between different areas of core company law.
2.15      The principles which were identified in the context of shareholder remedies were:

(i) The proper plaintiff principle: that is, that normally it is only the company which should be able to bring proceedings to enforce a cause of action to which it is entitled.^[22] This principle as such is specific to shareholder remedies and has no application here. However it is indicative of the relationship between those who control a company and individual shareholders. The latter have invested in the company and have sunk their monies into a common pool which it is likely that others will control. The duties which directors owe are owed to the company and not to individual shareholders.

(ii) The internal management principle: that is, that the court should not be involved in the resolution of disputes that under the company's constitution are determined by the vote of the majority. This principle is concerned with the relationship between an individual shareholder and the general body of shareholders and therefore as such it has no application to the field with which this project is concerned. However it again indicates the fundamental premise on which company law is based, namely that individual shareholders having taken shares in a company have contributed to a common pool which they are unlikely to control.

(iii) The commercial judgment principle: that is, that the courts should not substitute their judgment for that of the directors on commercial matters provided that the directors' decision is itself arrived at by a satisfactory process. The threshold requirements which were identified for such a judgment were that the directors should have acted in good faith, on proper information and in the light of the relevant considerations and that it appears to be a reasonable decision for the directors to have taken. This principle is one which affects the field of action delegated to directors and in our view this policy issue here is an issue also in the field of Part X and directors' duties.

(iv) The principle of sanctity of contract: this is well known to lawyers and means the principle whereby a person is bound by the terms of the agreement that he made and the court is not given power to relieve him from that contract. In commercial life there is a high premium on certainty and this principle is conducive to certainty. This principle is not specific to shareholder remedies and thus an issue arises as to whether it is correct for directors' duties and dealings as well. It does not mean that the principle may never be modified. There are situations in which it is fair to give the court some discretion to relieve a party to a contract from the consequences of their action but those situations will be limited and form the exceptions rather than the rule.

(v) The principle of freedom from unnecessary shareholder interference: we explained that shareholders should not be able to involve the company in litigation without good cause or where they intend to cause the company or other shareholders embarrassment or harm rather than genuinely pursue the relief claimed. Otherwise the company may be "killed by kindness",^[23] or waste money or management time on dealing with unwarranted proceedings. We took the view that the way ahead was not that there should be a bar on shareholders bringing derivative proceedings save in very exceptional circumstances, but rather that the requisite control should be exercised by the courts. In that way the delicate balance of power between shareholders and their companies could be maintained.

(vi) The principle of efficiency and cost-effectiveness: We took the view that all shareholder remedies should be made as efficient and cost-effective as can be achieved in the circumstances. This principle is obviously a general principle and it clearly ties in with the emphasis on competitiveness in the DTI's Company Law Review. We see it as a principle of general application, and certainly as one that is capable of being applied to directors' duties and dealings.

2.16      The guiding principles summarised above were set out in the consultation paper on Shareholder Remedies, issued in October 1996. Consultees views were sought on them and they were well supported on consultation. The principles were criticised in legal journals^[24] as not articulating the fundamental values which company law ought to achieve and in this respect being insufficiently penetrating and analytical. We understand and respect those criticisms but consider that the task of this project is to formulate recommendations with respect to a limited part of company law which will form a contribution to the DTI's wider review of company law. Thus we have to work on the basis (so far as this project is concerned) that companies will continue to perform the same economic and societal role that is currently permitted by law. The debate as to any wider or new role is one which is of value but does not fall within the confines of this project.

Guiding principles for directors' dealings and duties?

2.17      We suggest for consideration by consultees that the following are the key principles that should apply in the area of core company law covered by this project:

(1) A principle of separate but interdependent roles for shareholders and directors: We provisionally consider that any reform of the law in this area should recognise that the roles of shareholders and directors are separate but interdependent. Of course, the precise roles may be varied by the articles in some companies such as joint venture companies, or in practice where the shareholders are all directors and the distinction between their two roles is blurred. But the law should start from the recognition that usually directors and shareholders have quite separate roles in the company.^[25] Directors manage the business while shareholders monitor their stewardship. However the roles of shareholders and directors are mutually interdependent and the law should strike an appropriate balance between their respective interests. Shareholders are not in a position to control the activities of directors on a day to day basis, and this means that the law has to impose some restrictions on the activities of directors. On the other hand management must also have freedom from unnecessary shareholder interference. This freedom is one of the principles identified in the Law Commissions' Shareholder Remedies project.^[26] In the context of shareholder remedies, this principle was left to be mediated through the courts. That is less likely to be the route available in this context and therefore care has to be taken to see that where it is absent there are other mechanisms to subject directors to appropriate scrutiny and sanctions.

(2) Law as facilitator principle: Law in this area should facilitate and not impede the conduct of proper business transactions. We have already referred to this in paragraph 1.14 above.

(3) Appropriate sanctions principle: There must be a flexible range of sanctions and consideration should be given to whether the existing sanctions for any particular breach are effective and realistic. This raises the sub-issue of decriminalisation of Part X, which we discuss in Part 10 below.

(4) A company-specific principle: The rules which emanate from this project must be tested against the different sorts of companies to which they apply and where appropriate different rules should be devised for different types of company. This raises the question of how companies are appropriately classified in this area.

(5) An inclusive principle: In Part X generally and in the formulation of directors' duties under the general law, due regard must be paid, to the extent to which the law from time to time allows this,^[27] to the obligation of directors to consider other constituency interests apart from those of shareholders. In this respect, the law must have an inbuilt elasticity to permit organic growth and development.

(6) A usability principle: The law in this area must be accessible, comprehensible, clear and consistent with common sense. It must also meet business needs and be built on a proper understanding of how business works.

(7) A certainty principle: The prescriptive rules of Part X must be clear and certain so that directors can be advised or decide for themselves without difficulty whether a particular transaction falls within their ambit or not. There is rather a special need for certainty in this area because generally there is no time to go to court to determine the question of law: the opportunity which it was desired to pursue will no longer be capable of being pursued if the parties have to wait for a court decision. But the principle of certainty as we see it has to be applied with caution. First, the existence of prescriptive rules can sometimes be self-defeating: because they are construed very literally, it is often possible, with a little ingenuity, to "drive a coach and horses" through them.^[28] In circumstances such as these the courts have sometimes, but not often, been prepared to recharacterise the transaction^[29] and in tax law the courts have gone further and devised rules to disregard artificial transactions.^[30] Second, it is also the case that even in the Companies Acts Parliament has had to include provisions which are very general and imprecise, such as "shadow director",^[31] "subsidiary undertaking",^[32] "financial assistance",^[33] directors' "interests" in transactions.^[34] While therefore we see that in general the rules of Part X should be abundantly clear in their scope, we consider that users of company law must recognise that there are going to be situations where, from the nature of the subject matter, this is not achievable.

(8) An "enough but not excessive" principle: Part X must strike the right balance between necessary regulation and freedom for directors to make business decisions. It should not be criticised simply for failing to deal with every possible permutation of facts or eventuality. Part X should ideally seek to regulate in those areas and in those ways in which legal regulation can be effective. If consultees agree with this statement in principle, we invite them to give us their views as to how effective regulation might be achieved. It may be difficult to apply the ideal without research which may not be currently available. This ideal also leads to the question of what legal doctrines should be developed and/or legislated for to achieve the most effective regulatory result.

(9) A principle of ample but efficient disclosure: Disclosure, like sunlight in Justice Brandeis' famous phrase,^[35] is the best disinfectant. It is one of the best ways of achieving high standards, since, although directors are not prohibited from doing that which they have to disclose, they will not in general be willing to see disclosed that which, though not illegal, may subject them to criticism. On the other hand disclosure carries its own cost, both direct and indirect, and the consequences of information being available in the public domain. Care must be taken to ensure that the costs of disclosure do not outweigh its utility.

(10) The principle of efficiency and cost effectiveness: As with the law relating to shareholders' remedies, the law in the field covered by this project too must be made as efficient and cost-effective as can be achieved in the circumstances. Thus in the context of disclosure it is important to bear in mind not merely the need to avoid the risk of information overload, but also the waste of costs and management resources which may result from an obligation to disclose information to shareholders which shareholders do not need to perform their function. Such waste tends to diminish a company's ability to perform well and to be competitive.

(11) The commercial judgment principle: There are areas of company law in which the courts pass judgment on what are essentially commercial matters, such as whether putting a company into administration is likely to lead to its survival as a going concern.^[36] But the general principle, in a review of an act said to have constituted a breach of duty, should be that the courts do not substitute their judgment for that of the directors made in good faith. In the context of this project the rationale for such a principle may be more a need to provide the right incentives to directors to take proper commercial risks, than because the courts would not be able to review the commercial wisdom of the decision. On the other hand there will be circumstances where despite this general approach the court has to reject the view of the directors, for instance because they acted for an irrelevant purpose.^[37]

(12) The principle of sanctity of contract: This principle, and its importance as a commercial matter, are explained above.^[38] There are, however, examples within the scope of this project where the company is relieved of a contract because some mandatory rule in Part X or the general law is not complied with. In addition, the court has power under section 727 of the Companies Act 1985^[39] in limited circumstances, to relieve a director from the consequences of breach of duty. The matter can be approached on the basis that these points only illustrate the principle. The starting point is that the law will generally uphold contractual relationships .

Consultees are asked whether, in their view, the appropriate principles to guide reform in this area are those set out at paragraph 2.17 above; and/or whether some other, and if so what, principles should apply for that purpose.

2.18      It can be seen that law reform in this field has in many respects to be tested against the efficiency of the relevant legal rules in achieving the desired measure of control. Because of that, we consider that the questions to which this project gives rise are not purely legal ones: in many respects they are also economic ones. We are not alone in seeing a role for economics in company law. Much important work in company law using economic analysis has already been done in this country.^[40] We turn next in the next Part to a study of the economic considerations applicable to this project, which we believe give an added dimension to this law reform exercise. The study has been carried out for the Law Commissions by the ESRC Centre for Business Research at the University of Cambridge.^[41]

Note 1   DTI's Consultative Paper, para 5.1.    [Back]

Note 2   Ibid, at para 5.2.    [Back]

Note 3   Ibid, at para 7.2.    [Back]

Note 4   Ibid, at para 8.2.    [Back]

Note 5   Ibid, at para 8.2-8.3.    [Back]

Note 6   Corporate Law Economic Reform Program, A strategy document, Australian Treasury, March 1997.    [Back]

Note 7   The detailed provisions of the different statutes vary, but overall the provincial Acts are drafted in similar terms to the CBCA.    [Back]

Note 8   The Commission was established by the Law Commission Act 1985 to promote the systematic review, reform and development of the law of New Zealand. Its remit is also to advise on ways in which the law can be made as understandable and accessible as practicable.    [Back]

Note 9   NZLC R9 (June 1989).    [Back]

Note 10   NZLC R16 (September 1990).    [Back]

Note 11   Recommendations for draft legislation to replace the Companies Act 1955 (the Act having been based on the UK Companies Act 1948) had also appeared in the Commission's 8th Report, "A Personal Property Securities Act for New Zealand" (NZLC R8, April 1989).    [Back]

Note 12   See NZLC R16, p xvii.    [Back]

Note 13   It came into effect on 1 July 1994, although parts of the old legislation remained in force until 1 July 1997.    [Back]

Note 14   This is the starting point. As stated in paras 1.47 and 2.17, in some cases the directors are also owners of the enterprise and the roles of directors and shareholders are then often treated as merged.    [Back]

Note 15   See para 11. 28 below.     [Back]

Note 16   Ie once it became the policy to include in the Act some very specific prohibitions, it became difficult to resist the argument that it should not contain a number of further prohibitions in the same style.    [Back]

Note 17   See eg ss 330-343.    [Back]

Note 18   See eg s 317.    [Back]

Note 19   See eg ss 312, 323.    [Back]

Note 20   See eg s 324-9.    [Back]

Note 21   Para 2.2 above.     [Back]

Note 22   In Scots law the rules on title to sue achieve a similar result. See, Shareholder Remedies (1997) Law Com No 246, Appendix D.    [Back]

Note 23   Prudential Assurance Ltd v Newman Industries Ltd (No2) [1982] Ch 204, 221.    [Back]

Note 24   D Sugarman, "Shareholder Remedies and the Law Commission's consultation paper" (1997) PIC 3 and "Reconceptualising company law: reflections on the Law Commission's consultation paper on shareholder remedies: Part 2" (1997) Co Law 274; Report from the CCLP, IALS by Dr Leslie Moran, "Shareholder Remedies Workshop" (1997) Co Law 93; Professor William Rees, "Shareholder Remedies" [1997] 5 ICCLR 155; CA Riley, "The values behind the Law Commission's consultation paper" (1997) Co Law 260.    [Back]

Note 25   See para 2.12 above.     [Back]

Note 26   See para 2.15(v) above.     [Back]

Note 27   But no further, because the stakeholder issue is outside this project: see para 1.55 above.     [Back]

Note 28   See for example the practice of "rolling contracts" referred to under s 319 at para 4.169 below.    [Back]

Note 29   See for example the doctrine of sham in relation to mortgages (applied in eg Welsh Development Corporation v Export Finance Co [1992] BCLC 148.    [Back]

Note 30   See eg Ramsay(WT) Ltd v IRC [1982] AC 300.     [Back]

Note 31   Section 741(2).     [Back]

Note 32   Section 258.     [Back]

Note 33   Sections 151-158.     [Back]

Note 34   Section 317.     [Back]

Note 35   Louis D Brandeis, Other People's Money (1914) p 92. Justice Brandeis was a Justice of the Supreme Court of the United States of America from 1916 to 1939.     [Back]

Note 36   See Insolvency Act 1986, s 8.    [Back]

Note 37   Similarly, the court would probably not be bound by the directors' view on a commercial matter if it was manifestly unreasonable or was made on the basis of inadequate information: cf Charterbridge Corporation Ltd v Lloyds Bank Ltd [1970] Ch 62: see para 11.29 below.    [Back]

Note 38   See para 2.15(iv) above.    [Back]

Note 39   See paras 11. 41-11.45 below.     [Back]

Note 40   See for example Prentice, "The Theory of the firm: minority shareholder oppression: sections 459-461 of the Companies Act 1985" (1988) OJLS 55; Ogus, "Economics and Law Reform: Thirty years of Law Commission endeavour" (1995) LQR 407; B R Cheffins Company Law: Theory, Structure and Operation (1997); Parkinson, Corporate Power and Responsibility (1993); and Ogus, Regulation: Legal Form and Economic Theory (1994).     [Back]

Note 41   The Report was prepared by Simon Deakin and Alan Hughes, respectively Assistant Director and Director of the ESRC Centre for Business Research.    [Back]