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A Critical Examination of the Impact of Section172 of the Companies Act 2006

Priya Gopal

There has been a plethora of debate surrounding the approach to directorialdecision making in the scheme of corporate governance. A divergence hasemerged between numerous schools of thought as to whose interests thedirectors are to consider in conducting the companys management. Theapproach under English law is codied under section 172 Companies Act 2006(CA 2006) which professes an enlightened shareholder value approach tocorporate governance. This has given rise to scrutiny and challenge fromnumerous critics but most notably from proponents of the stakeholdermanagement stance. The aim here is therefore to evaluate the scope andimpact of section 172 and consider the possible alternatives whilst seeking toestablish whether section 172 can be considered a positive development withincompany law.

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1. Previous approach

Under the common law, directors were required to act in good faith in what theybelieved to be in the companys best interests. The main problem was that thecompany is a legal abstraction and acting in the companys interests is a fairlyobscure and elusive concept; thus reform was necessary so that directors couldascertain what the companys interests actually entails i.e. whose interests it isreferring to[1]. Moreover, under section 309 Companies Act 1985, directors wereto have regard to the interests of the company's employees in general, as wellas the interests of its members. This suggested that members and employeescould feature in decision making but there was no stipulation as to whoseinterests were predominant and directorial discretion was arguably too wide. Theprovision was also quite otiose given that employees had no right of enforcementand reform was needed to restore some clarity.[2]

2. Section 172 CA 2006 Section 172 inaugurated an enlightened shareholder value (ESV) approach sothat directors, in fullling their duty towards the company[3] are required to actin the way [they] consider, in good faith, would be most likely to promote thesuccess of the company for the benet of its members as a whole, and in doingso have regard to other factors insofar as they promote the companys interests;thus, the legislation equates the interests of the shareholders with the companyssuccess. Although other factors such as, inter alia, the companys employees[4],suppliers and customers[5], the long term consequences[6] etc. are to feature indecision making, these factors will be subordinate to the interests of theshareholders. Thus, the intention of the provision is not to engender a


surreptitious adoption of stakeholder management, as the assertion suggests,since the interests of other stakeholders are only instrumental to ensuring thatthe company is profitable which is causatively linked to the members interests. The imposition of a subjective standard by requiring good faith appears primafacie to be counterproductive to consistency as it does not appear to set anythreshold standard for directors. Nonetheless, the Guidance illustrates thatcompliance with section 172 is supplemented by the duty of care embodiedunder section 174 thus providing some form of objectivity given that directors arerequired to act with a degree of reasonable care, skill and diligence.[7] InRegentcrest v. Cohen,[8] Parker J articulated that a subjective standardnecessitates a consideration of what the director genuinely and honestlybelieved was conducive to promoting the companys success. This, in conjunctionwith good commercial reasons[9] for acting entitled the High Court to concludethat a policy to excuse the debts of the directors was advancing the success ofthe company since it was valuable for the company to retain their directorialservices. Although this decision was reached in a climate where proper purposeand bona de were amalgamated, it is submitted that even now a similarapproach would be taken, as directors are required to act in accordance withsection 174. The courts seem reluctant to interfere with directorial decisions onthe premise that corporate entities should be largely administered by internalmanagement save to the extent that legal input is unavoidable. Directors are in abetter position to meet the demands of the individual company[10] and thecourts thus adopt a non-interventionist stance. Therefore, the subjective standardis a positive development in the law since it appreciates the need for decisionmaking to be resolved internally. The CA 2006 has been criticised for reserving the notion of success to the


directors individual judgment. The view that a company is organised and carriedon primarily for the prot of the [shareholders] has been articulated in the USdecision of Dodge v. Ford Motor Co.[11] Faure has said that this also reects theEnglish approach.[12] This appears correct since commercial advancement is acentral company objective and the case law demonstrates that extraneousconsiderations like climate change should not be furthered to the detriment ofthe value of shares.[13] Nonetheless charitable companies[14], for instance, arenot commercially motivated and so success is largely measured by value but notalways. In the context of directors contracting so as to fetter their future discretion, therehas been some ambivalence as to whether such contracting is conducive tocompanys success. The conventional stance indicated that fullling a contractualundertaking with a third party would inevitably generate inconsistency with thecompanys interests.[15] Nonetheless, this has subsequently been qualied and inFulham FC v Cabra Estates,[16] Neill LJ accepted that contractual arrangementsconferring substantial benets on the company should not be prohibited. Therationale here is arguably that the legislature could not have realistically intendeda blanket ban on such contracting at the expense of the companys commercialsuccess since it would undermine the underlying policy behind the provision.Thus, section 172 can arguably be viewed as an eective development inensuring that the companys success is always at the forefront of decisionmaking. It can be inferred from Keays assessment of section 172 that the provision maysuer from the problem of enforcement, thereby repeating the deciencies ofsection 309.[17] Generally, claims will only be brought by virtue of a derivativeclaim by shareholders[18], liquidators upon insolvency[19] or by a new Board


upon transfer[20]. Thus, the view that the provision will engender stakeholdermanagement is misguided because other stakeholders have no means ofenforcing the provision. Moreover, given the litigation costs and the diculties insurpassing the derivative claim preconditions, it will be dicult to mount asuccessful claim against a defaulting director. Furthermore, there is a concernthat the have regard to list will make it more dicult to challenge decisionsbecause directors will be able to justify their approach on any of the enumeratedfactors.[21] This concern is valid but the non-exhaustive list helps to retainexibility given the dynamic nature of the corporate form. Even so, it is arguedthat section 172 is not necessarily a positive development because it will bedicult to ensure that the provision has some de facto impact given the limitedaccountability available.

3. Enlightened Shareholder Value (ESV) approach An argument in favour of the ESV approach derives from the fact thatshareholders are deemed the equity owners of the company as they possesscontrol and ownership rights[22] and thus it is justied for decisions to be taken intheir interests. In contention to this, it has been argued that equating theshareholders interests to that of the company undermines the separate legalentity principle which resonates throughout company law.[23] Although Irelandpresents a justiable concern, it is submitted that directors are under onerousduciary duties and there needs to be some touchstone as to whose interests areto be prioritised as a matter of eective decision making. One reason forpreferring the interests of shareholders has been oered by Bainbridge[24]:under a contractarian approach, the company can be viewed as a nexus ofcontracts where parties such as employers and creditors contract so as toprovide dierent contributions to the company. Their interests are capable of


being suciently protected through contract and there is the danger thatshareholders will not invest if their interests are not adequately protected. Insupport of this, it can be said that not only can the interests of other parties beprotected by contract but provision is also made under the CA 2006. For instance,under section 247, directors can act to benet employees and ex-employees inconnection with cessation or transfer of undertakings notwithstanding the dutyunder section 172. Thus, section 172 is required as a matter of necessity toensure that shareholder interests are protected since other stakeholdersinterests can be protected using alternative mechanisms. Additionally, shareholder benets uctuate depending on the companys successunlike creditors who are repaid a xed sum. Shareholders are risking the mostthrough their investment and should consequently be prioritised[25]. Keay[26]has counteracted this by elucidating that shareholders are not the only risktakers; employees take risks by investing in training which is only suited to aparticular type of corporation which thereby restricts individual development. Insupport of this, it is submitted that risk taking is not a strong enough justicationfor prioritising shareholder interests and a better vindication is that when thecompany is solvent, the shareholders interest is at stake and thus their interestswarrant protection. Upon insolvency, the creditors interests prevail and where adirector is guilty of substandard conduct, claims are always actionable by theliquidator under the wrongful[27] and fraudulent trading[28] provisions so as toenforce the creditors interests[29].

4. ReformThe strongest challenge to the ESV approach has been proered by advocates ofthe pluralistic/ stakeholder management approach (SMA) which was rejected bythe Company Law Review Steering Committee[30] before section 172 was


enacted. The SMA requires directors to balance the interests of dierentstakeholders who have contributed to the company[31]. An illustration of this canbe found in the Japanese model where the interests of suppliers, employees,creditors and shareholders are to be considered equally by directors in managingthe company[32]. Some useful research by Okabe[33] illustrates that the schemeof corporate governance adopted by a jurisdiction correlates with the way it isnanced. In Japan, there is a greater reliance on debt funding since companiesare controlled and maintained on a long term basis by the main banks.[34]Additionally, the lifetime employment tradition in Japan demands a sucientregard to employee interests.[35] Japanese businesses are also dependent onagreement between the stakeholders; thus, the nature of nancing and functionof companies necessitates a SMA to protect the highest contributors to thecompany. Conversely, under the Anglo-American approach, as a corollary ofreliance on equity funding, a shareholder-dominated stance seems moreappropriate. We should therefore dispel the idea of enacting a SMA given that it isinconsistent with entire purpose of companies in generating wealth for investors.Furthermore, Odenius[36] identies that the SMA can be regarded ascounterproductive to achieving corporate governance objectives because itpresents an inherent conict between competing considerations. In support ofthis, it can be said that such a balancing process will render the decision makingprocess convoluted and inecient so as to detract directors attention fromensuring that the company is protable. Moreover, under a SMA, directors wouldhave a broad power in carrying out their duties and extensive degrees ofconsideration; this would probably lead to an increase in agency costs given thatmore money will be incurred to monitor their activities[37]. The academic response to section 172 demonstrates a dichotomy between theshareholder and stakeholder value ideologies. The approach embraced by Englishlaw establishes a happy medium between these extremes and is an eective way


of accommodating the interests of all those involved in the company. Theinsinuation that section 172 introduces stakeholder management is erroneoussince the enumerated factors are merely instrumental to the principal purpose ofensuring that the company is successful for the benet of the members. Despiteits exibility, it is advanced that section 172 provides guidance, butsimultaneously appreciates the need to defer management to directors, and socan be regarded as a positive addition to decision making in the wider scheme ofcorporate governance.Bibliography: Articles:Paddy Ireland, Company Law and the Myth of Shareholder Ownership (1999) 62Modern Law Review 32 Sarah Bainbridge, In defence of the Shareholder Wealth Maximisation Norm: AReply to Professor Green (1993) 50 Washington and Lee Law Review 1423 Andrew Keay, Tackling the issue of the corporate objective (2007) 29 Sydney LawReview 577 Roberta S Karmel, Implications of the Stakeholder Model (1993) 61 GeorgeWashington Law Review 1156 Yuzuo Yao, Historical Dynamics of the Development of the Corporate Governance


in Japan, Journal of Politics and Law (2009) Books:Henry Hansmann, The Ownership of Enterprise (Harvard University Press, 2000) Frank H. Easterbrook and Daniel R. Fischel, The economic structure of corporatelaw (Harvard University Press, 1st edition, 1996) Michael Faure, Globalization and private law (Edward Elgar Publishing, 2010)Len Sealy and Sarah Worthington, Cases and Materials in Company Law (OxfordUniversity Press, 9th edition, 2010) Paul L. Davies, Gower and Davies Principles of Modern Company Law (Sweet &Maxwell, 8th edition, 2008) Reports:Company Law Review Steering Committee, Modern Company Law for aCompetitive Economy: The Strategic Framework (1999) Jrgen Odenius, Germanys Corporate Governance Reforms: Has the SystemBecome Flexible Enough? (IMF Working Paper, 2008)


Mitsuaki Okabe, The Financial System and Corporate Governance in Japan, Policyand Governance Working Paper Series No. 17 (2004)

[1] Brady v. Brady [1988] BCLC 20 at p. 40[2] Gower and Davies (2008), p. 508[3] CA 2006 s. 170(1)[4] CA 2006 s. 172(1)(b)[5] S. 172(1)(c)[6] S. 172(1)(a)[7] Companies Act 2006: Explanatory Notes, para. 328[8] [2001] B.C.C. 494 at [141], [158][9] Ibid, [145], [148][10] R. (on the application of People & Planet) v HM Treasury [2009] EWHC 3020 at [35][11] 170 N.W. 668 (Mich. 1919), per Ostrander CJ[12] (2010), p. 228[13] Supra n.8 at [34][14] Supra n.2, p. 511[15] Boulting v Association of Cinematograph, Television and Allied Technicians [1963] 2 Q.B. 606,Lord Denning MR, p. 626[16] [1992] BCC 863, p. 876[17] (2007), p. 110[18] CA 2006, s. 260[19] IA 1986 s. 212


[20] In Plus Group Ltd v Pyke [2002] BCLC 201[21] Sealy and Worthington (2010), p. 322[22] Hansmann (2000), p. 11[23] Ireland (1999), p. 49[24] Bainbridge (1993), p. 1442[25] Easterbrook and Fischel (1996), p. 36[26] (2007), p. 585[27] Insolvency Act 1986, s. 214[28] Ibid, s. 213[29] West Mercia Safetywear Ltd v Dodd [1988] BCLC 250[30] (1999), ch. 5.1[31] Karmel (1993), p. 1171[32] Yao (2009), p. 169[33] (2004), p. 6[34] Ibid, p. 8[35] Supra n.31[36] (2008), p. 7[37] Supra n.25, p. 583

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