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Comparative Company Law

The current era can be featured by numerous corporate crashes and managerial misconducts. The major corporate constituent that has got a lot of attention regarding corporate governance is the company shareholders. Particularly, institutional investors are believed to have monitoring functions in the company, while empowering shareholders appears to be a hot theme of numerous reform plans. The change from a director priority framework to a shareholder priority framework is apparently not beneficial. Some supporters of shareholder empowerment provide numerous arguments about why shareholder engagement can be seen as advantageous. Nevertheless, the current paper will demonstrate that shareholder engagement cannot be manifested as the primary solution to the problem. The paper will define legislative and non-legislative barriers for shareholder engagement, making the corporate governance deus ex machina. Therefore, the UK regulative reaction to the financial crisis in the form of ‘stewardship’ and shareholder engagement can be seen as an error based on the wrong understanding of the major active functions that shareholders performed in the significant collapse of corporate governance caused by the banking crisis.

Corporate Governance Issues

Analysis of the UK Financial and Banking Crisis and Corporate Governance

The financial crisis has caused numerous complications because the recent general corporate governance reform in the UK has led to control being taken over the long-term shareholder’s engagement via the unclear notion of stewardship. Generally speaking, the application of stewardship is problematical in the UK due to a serious misbalance in the authoritative structure of UK companies. This misbalance makes corporations especially sensitive to shareholder activities, which typically pay particular attention to short-term profits neglecting the long-term company interests. The corporate governance issues in the UK banks, which actually caused the financial crisis, together with the regulative reform reaction clearly demonstrate how the short-term activity of shareholders can appear problematical and how the legislative reaction in the form of shareholder empowerment and stewardship is inappropriate.

It is known that banks have specific characteristics as organizations.

  • Firstly, banks act with obvious and unspoken government guarantees, which seriously encourage their operations.
  • Secondly, these state guarantees were used concerning three big and two small UK banks in 2008. Therefore, these banks are currently efficiently working in the form of state-property ventures.
  • Thirdly, the history and funding of banks provide banks with unique inner corporate governance problems. The exceptional status of the bank can also be used to show the extremes in the UK private shareholder-agent framework and provide an understanding of why shareholder-focused resolutions appear to be an element of corporate governance issue and not the solution.

The global financial crisis in 2008, appearing as a combination of technologic progress and removal of fund control, concentrated global financial resources in merely 145 banks. Practically, all of them were universal banks, having operations across the full range of the financial sphere with their total firm capitals exceeding 100 billion each. By 2008, the five greatest global banks had 16 percent of the world’s banking capital. The UK banking sphere increased significantly, demonstrating 50 percent of the state GDP in the 1970s and 500 percent in 2010.

The development and increase of the banks together with the governmental grants on their operations are clearly connected. The importance of each of these banks does not merely regard the fact that they have been too big to fail (also known as TBTF), but also the fact that an administrative help to a TBTF bank could still reveal a sabotaging systemic impact on the world’s financial system. It practically means that the size of the banks did not allow the government to safely manipulate the bankruptcy of one or several, in the worst case, TBTF banks, even with systematic international support.

Financial Crisis as the Main Reason of Long-Term Shareholder Engagement and Stewardship

The year 2007 demonstrates how artificially decreased interest rates caused a financial and banking boom. All global central banks were stopping liquidity to the financial system when interbank lending started to announce fear regarding the possibility of TBTF bankruptcy. Due to the fact that the banks and their guarantee providers started to report serious credit-connected losses in 2008, the Bank of England broadened its financial backing for banks and decreased interest rates. When the financial collapse became stronger, the government nationalized Northern Rock, which was supported by the Bank of England. The bankruptcy of Lehman Brothers in 2008 changed the financial collapse almost into a disaster by demonstrating the interconnection of obligations of the main financial institutions. As investors were shocked by this, they took the capital from the global financial system at a fast rate. Therefore, in order to prevent the bankruptcy of the financial system, the global central banks provided serious funding into the system. In addition, three TBTF UK banks, including HBOS, Lloyds TSB and the Royal Bank of Scotland, were efficiently nationalized. The UK government’s financial commitment to its banking sphere reached more than 70 percent of GDP in 2009. In 2011, the UK government cut public sphere spendings in order to handle the cost of the financial and banking collapse, which had essentially lowered the overall state income. Moreover, the earnings of bankers appeared as a serious UK corporate governance issue. The legislative reaction demonstrates that earnings and risk-taking were connected with the bankrupted banks. In addition, shareholders either took part in this short-term risk-taking, or they left the sphere after understanding the real size of the risk.

Shareholder Value Model of Corporate Governance

The shareholder value framework of corporate governance dominates the corporate governance regulations in the UK. This type of corporate governance evaluates the performance of a company on the basis of company shareholder value and its payment of funds to shareholders. For this reason, this model reveals that company authorities have an obligation to perform the company operations in a manner that satisfies its present and future shareholders. Generally speaking, the principle of limited responsibility appeared on the basis of two principal arguments. The first states that limited responsibility is necessary for providing small investors (meaning shareholders) with safety, otherwise they will not use funds. The second argument states that people should be capable of contracting with each other in accordance with the condition of limited responsibility without any government intervention. The use of limited responsibility in public companies resulted in the fragmented ownership of UK companies since a higher number of individuals want to invest, thus making shareholding broadly spread. In fact, the innovative class of managers was provided with solid independence regarding their company regulation.

The Evolvement of the Shareholder Value Theory

The facts do not demonstrate clearly when the shareholder value theory actually became important in the UK. It is known that the theory was accepted in the US for the first time in the 1930s through the work of Berle and Means known as The Modern Corporation and Private Property. The thesis created and suggested by Berle and Means is the earliest and most broadly acknowledged academic report of the shareholder value theory that became the basis for corporate governance. Berle is known to be “the grandfather of modern shareholder primacy” due to his statement that a corporation exists merely to make profits for its shareholders (the concept known as the shareholder primacy). In the 1960s, a huge number of big corporations supported the idea that they should work taking into account the interests of the public. They understood that they could not exist in contemporary society without understanding the objectives of people and the economical and societal forces, which shape society. Nevertheless, Milton Friedmann, the Nobel-prize-winner economist, disagreed with the debates regarding the societal responsibility of business due to the regular carelessness and the lack of attention. Friedman believed that the mere societal responsibility of business was connected with the ability to operate and increase its profits. In addition, Friedman believed that corporate managers were supposed to run profit-making operations and the money earned could be later distributed again by the government in order to improve economic imbalance. These views were controversial and encountered some opposition, especially from Martin Lipton. He said that the contemporary corporate governance model had to place directors at the center of the corporate decision making and increase the corporation’s obligations in order to secure the interests of others except for the shareholders. The concept by Friedman became popular through the help and additional ideas of other scholars, and it got the leading status, which it actually enjoys nowadays. Michael Jensen and William Meckling were among those scholars. They promoted the agency theory, property rights theory and finance theory in order to evolve the theory of the company ownership structure. They believed that freedom of ownership and control, which is present in current corporations, was closely connected with the overall issue of agency. They were the ones who created the concept of the corporate holder/manager who owned all company shares and could sell a part of these shares to external shareholders. In fact, Jensen and Meckling discussed that when the property corporation structure involved fair ownership by managers, their interests appear in line with the shareholders’ interests. Moreover, Jensen developed the original thesis in 2001 claiming that shareholder capital maximizing could result in socially effective solutions and reduction of societal waste. Nowadays, there is a wide agreement amongst academics, business and state elites regarding the fact that the shareholder category is supposed to have the principal control over the corporation and that managers are supposed to perform their functions paying particular attention to the shareholders’ interests. Nevertheless, it does not mean that all people agree that other non-shareholder categories should appear as insecure.

Historical Vulnerability of the UK

Board Duties and Discretion in the UK

The global financial crisis has actually demonstrated the high level of the UK boards’ vulnerability regarding the active shareholders. This is specifically significant due to the fact that this vulnerability actually guides the whole development regarding the shareholder empowerment in the corporate governance reform. Generally speaking, the center of the corporate power structure control belongs to those who form it. The authorities of a typical company, including the board and the general management, work as a standard tool for individuals forming the company. Regardless of the fact whether or not people forming the company used the regulations while creating the board and general management, the inner regulations developed by the creators become the company regulations and the shareholders and authorities have to follow them unless the majority changes these regulations.

When there is a contract regarding the intention or unwillingness to follow the regulations, the court will have to define the result. In fact, the manner in which the law system deals with directors’ rights and duties in order for them to operate and act in the interests of the company demonstrates both the complex nature of the problem and the future of corporate responsibility.

The facts demonstrate that the most significant role of the articles regarding association is to divide the company’s authority between the board and the general management. Such division of authority is illustrated in articles 3 and 4 of the model standard articles (public and private) and claims that the Companies Act of 2006 provides an ordinary shareholders majority to release the board from its responsibilities. This practically means that authorities are supposed to treat both problems carefully regardless of their force. Nevertheless, the constitutional practice demonstrates that the empowered board has an independent right to operate the company. The main risk of such independence deals with the fact that the management can use its right in order to make a profit for itself and not the company. Taking into account this risk, the law system created a number of specific duties for authorities to limit their authoritative force. The general duties of directors are presently systematized and arranged in the Companies Act of 2006, and they include six points: “(1) the duty to act within their powers; (2) the duty to promote the success of the company; (3) the duty to exercise independent judgement; (4) the duty to exercise reasonable skill and diligence; (5) the duty to avoid conflicts of interest; and (6) a duty not to accept benefits from third parties” .

While developing the above-mentioned responsibilities, the UK law system revealed that keeping the balance between the directors’ rights and obligations to shareholders cannot be regarded as a simple objective. Therefore, the law system created resolutions on the question of who the authorities are responsible for when they use their power. Firstly, they are responsible for the company. This seems to improve and increase the independence of the authorities as the company is a separate lawful body. The reality shows that this leads to problematic situations when one tries to define the interests of the company. It creates a situation when shareholders can simultaneously be separate from the company and be its essence. While resolving this difficult reality, the law system emphasizes the director’s function in explaining the company interests. This means that in a particular setting, authorities can neglect the desires and interests of present shareholders on the basis of the long-term shareholders’ interests or balance of these two issues.

Application of Shareholder Value in the UK

The maximization of shareholder value is a common position in the UK. The main cause of this widespread acceptance includes the capital markets globalization, increase of institutional investors, higher level of shareholder activity and the rising significance of corporate governance. The facts show that the shareholder value standard demonstrates comparatively unnoticeable existence in the UK. Presently, it has not been formally acknowledged as a lawful regulation or concept, and it appears as an academic idea that impacts the conduct of the large public-listed companies’ management. Shareholder value has been recently provided with some kind of lawful status in the form of the enlightened shareholder value principle, which states that “a director of a company must act in the way he considers, in good faith” as this can most apparently provide the success to the company and benefit all of its members . This idea clarifies that authorities are supposed to see shareholders’ interests as the leading ones. The facts demonstrate that shareholder value has been made as a banking target in the UK, even before the moment when it got at least some legislative ground. Numerous banks did this by exchanging their common shares in order to raise return on equity, while numerous boards in the UK offered greater portions of wealth created by the company to shareholders as a profit instead of using it again in the company. Due to the fact that deregulation caused increased competition in the banking sector, shareholder value appeared as externally focused, turning into the means of measuring banking effectiveness. Nevertheless, facts reveal that this increased payment of profits to shareholders lowered the financial protection, which is required to secure oneself in case of an economic crisis, which actually appeared. Shareholdings had been massively spread, while the institutional investors appeared as greatly insignificant players. Moreover, both shareholders and institutional investors became passive for a long time and were unable to efficiently examine and control the decisions of boards and executive management in the banking sphere. Facts reveal that numerous institutional investors voted in support of gains, which were destructive for the value. Therefore, it is obvious that the lack of efficient corporate governance of banks is the main reason for the appearance of corporations without owners.

Corporations Without Owners in the UK

The Role of Institutional Shareholders

The UK traditional institutional shareholders, including pensions, insurances and general investment funds that create the UK’s shareholder-focused corporate governance model to fit their requirements, are seen as stopped. The legal and obligations changes together with the change in pension-membership demographics in favor of current returns are the main reasons for this reality. All of them have been switched by increasing the amount of passive overseas investors and short-term shareholders and traders. The effect of such changes primarily impacted the sphere of takeovers, in which rescue funds changed into the authoritative players due to the fact that institutional investors have bought them. This has raised the deformed function of the takeover panel in using board rights to the point when the board might require to actively secure the interests of the corporation. For this reason, the changes in the shareholders’ trading strategies, the increased use of high-technology algorithmic trading (robots), the division of liquidity across multiple trading exchanges and the final increased instability caused further dematerialization of the corporation and its share.

The UK’s Passive Ownerless-Corporation Issue

The facts demonstrate that the UK has a passive ownerless-corporation issue. Moreover, the banking crisis together with the shareholder ‘spring’ demonstrates that the UK has a problem of ‘shareholders on steroids’ . The unity of recently developed passive overseas shareholders and defenseless boards has provided active shareholders and traders with a possibility to concentrate on the short-term results. Moreover, the regulative reactions in the form of stewardship and shareholder empowerment are regarded as inadequate as they endanger the strengthening of this short-term tendency. The year 2012 showed that shareholders became extremely and unexpectedly active regarding the earnings votes (a period is known as “shareholder spring”). Nevertheless, the activity was concentrated on the poor current-shareholder-focused performance of authorities instead of disapproving higher levels of payments. The start of the UK’s shareholder-voting season demonstrated that employee bonuses were 2.15 billion, while the shareholder earnings reached merely 730 million, which showed that 31.4 percent of shareholders failed to keep the main authorities’ earnings. The votes on earnings during the ‘shareholder spring’ provided some shareholders with a possibility to fire authoritative directors and thus influence the strategic course as separate official votes on the firing of an authoritative director or a change of the course would almost certainly fail. Therefore, due to the fact that an opposing group is created behind the earnings votes, the short-term strategies can be applied.

Ineffectiveness of Stewardship and Shareholder Empowerment

The fact that some shareholders use earnings as the main tool to impact the strategic course of companies certainly opposes the ideal notion of stewardship. The practice of the UK demonstrates that shareholder stewardship is the dominant view on the function of shareholders. The UK shareholders have a tendency to keep from applying active control over public companies, which is combined with a comparatively passive approach to corporate governance. As a reaction to the financial crisis, policymakers desired to motivate the equity holders to take a more active approach, which led to the creation of the UK Stewardship Code. The global dominant understanding of shareholders demonstrates that these are institutional investors who are supposed to take a more active function within their investment companies due to the fact that they are provided with specific tools for this purpose and appear as the principal supporters of capital markets. Nevertheless, stewardship works merely when shareholders interfere by voting and persuading to execute their long-term objectives. On the other hand, when the confirmation or refusal of board operations is demonstrated merely by buying and selling shares, liquidity becomes highly important and the short-term nature of operations dominates. Therefore, long-term nature requires the active engagement of financial institutions. For the last three decades, corporate governance reforms in the UK demonstrated the topmost objective of increasing shareholder authority. The policy was believed to be progressive, thus making managers more responsible and improving the companies’ performance. The reality demonstrates that the empowerment of shareholders practically did not increase or improve managerial responsibility and had practically no connection to the creation of corporate value. Moreover, it contributed to numerous disadvantages of a financialised economy. They include a lower level of innovation and increased income differences. The facts show that the 2008 crisis appeared because of corporate governance reforms in the UK, and not in spite of them. Therefore, senior managers whose earnings were connected to increasing value prices had strong motivation to follow those strategies, which were directed at maximizing financial gains over a short period of time. Institutional shareholders actively insisted on deals that would ‘discharge shareholder value’ by changing the structure and using takeovers, thus allowing them to benefit from share buy-backs and increases in earnings, which made the capital flow move out of the productive economical spheres.

Reforms

Corporate Transparency Reforms

The facts demonstrate that the UK government has offered corporate transparency reforms in order to promote higher shareholder engagement with corporate communications. Therefore, corporate transparency has been established in public interest in the form of an exchange for the public prevention of risks in providing privileges to individuals who desire to direct a company via a corporate system . Generally speaking, an increased and required corporate transparency appeared through the regulation of securities development. The publicly-marketed corporation appears to be an icon of the marketized corporate economy, and this type of economy is kept responsible for the corporate creation of wealth via necessary corporate announcement by market credit and trust. This announcement is probably a significant establishment of the marketized corporate economy, and it is based on the appealing goals of deception prevention and investor securing, combined with the rise in market effectiveness.

Proposed UK Reforms

The governmental analysis of the UK corporate governance revealed that the country requires a higher level of shareholder engagement; therefore, it should be strongly encouraged. This is the main reason why the Financial Reporting Council (FRC) created the UK Stewardship Code. It aimed to stimulate the long-term wealth of companies and provide shareholders with a possibility to succeed from the financial perspective. This code was originally aimed at institutional investors with capital holdings in U- listed companies, and it works on a ‘comply-or-explain’ basis. This practically means that the code cannot be regarded as a strict collection of regulations, but a collection of guidelines and principles. Moreover, the FRC has been also responsible for creating a more general UK Corporate Governance Code in order to help boards to operate more efficiently and create a dialogue between the company’s board and its shareholders. This code also works on the ‘comply-or-explain’ foundation. The code states that despite the fact that the company is essentially responsible to its shareholders, while the connection between the company and its shareholders appear as the main focus for the company as well, companies are also encouraged to acknowledge the contributions made by other capital providers. This is a clear example of how ‘old habits die hard’ and how quasi-municipal non-governmental organizations provide confused concepts of what the regulation really states and promote inadequate ideas regarding banking management and authorities instead.

Adequacy of Reforms

Numerous scholars reveal their doubts regarding these proposals and recent reforms concerning their possibility to adequately enhance the corporate governance in banks in the long run. Despite the fact that numerous disagreeing investigation reports have each acknowledged that the banks’ concentration on shareholder value was an important contributing agent to the financial crisis; instead of blaming shareholders, the proposals and reforms try to provide increased authority to them through stewardship and encouragement to take part in the strategic engagement. It appears illogical that those who actually contributed to the issue (due to their short-term concentration on profit-maximizing) get additional authority. The provision of shareholders with additional authority sends particular message to company directors regarding the fact that they are supposed to pay more attention to shareholders’ interests, regardless of whether shareholders work with them or not. The previous experience demonstrated that an unexpected increase in shareholder activity (‘spring’) has not been based on any objectives regarding the rise of levels of directors’ payments but on dissatisfying shareholder-concentrated execution. Therefore, it becomes obvious that the provision of additional force to shareholders might result in merely the opposite effect than intended. In addition, the UK reforms fail to differentiate banks from other public-listed companies. The facts reveal that banks have an undetermined manner of performing business contrary to other company types. Therefore, it might be inappropriate to use similar regulations to banks and other public-listed companies. In addition, it is believed to be inadequate to continue to treat shareholders as owners, like it was in the 18th century. These businesses were specific partnerships, and their participant was really the owners of the business and had obligations and rights connected to this ownership. However, in the current banking institutions, shares are broadly spread and typically owned by institutional investors looking for short-term gains: the last group does not truly represent owners of the investment banks.

Alternative Ideas for Reform

It is recommended to empower banking authorities to take into consideration other non-shareholder interests. This idea might be argued by the fact that stimulation of directors to consider a broad range of non-shareholder interests instead of being impacted by shareholder value can make them less stronger and rational leaders as they lose the direction. Therefore, it is also recommended to develop particular indicators and targets for authorities to have understandable ideas regarding future goals and objectives. Similarly to how the shareholder value has been used as a sign and measure of company performance, some bank business figures, bank resources and the quality of issued loans might be used in order to analyze the performance of a bank. In addition, it is also recommended to invest in the board of directors as their main decision-making role is required to coordinate the frequently disagreeing interests of shareholders because they do not have basically formulated interests. Nevertheless, the provision of unlimited rights to the board of directors should not be allowed in order to cover self-interest. Therefore, the change in operation among banking directors and a cultural shift in banking institutions should be promoted through making the connection between directors’ earnings, the banks’ share price and change of the collection process of extra earnings with more modest ones. These actions cannot change the corporate governance and banking culture at once, but they can help move from old assumptions towards a real change.

Conclusions

The paper vividly demonstrates that the UK regulative reaction to the financial crisis in the form of stewardship and shareholder engagement can be considered as an error based on the wrong understanding of the main active functions that shareholders performed in the significant collapse of the corporate governance which appeared through the banking crisis. The financial and banking crisis resulted in numerous complications over the recent general corporate governance reform in the UK, leading to the prevention of long-term shareholder engagement via the unclear notion of stewardship. Generally speaking, the use of stewardship is problematical in the UK because of the serious misbalance in the authoritative structure of UK companies. This misbalance makes corporations especially sensitive to shareholder activities, which typically pay particular attention to short-term profits neglecting the long-term company interests. The current shareholder value theory appears to take a highly matter-of-fact approach to the concept of creating shareholder value, being concentrated on the short-term increase of the share value, neglecting the overall community. The currently proposed reforms cannot be considered as adequate since they put the focus on those who actually and seriously contributed to the financial crisis through their strong interest in the short-term value. The paper suggests alternative reform, which can actually help banks avoid the old shareholder value limits and enable the board of directors to balance and stabilize the interests of all participants.