The future of company law and corporate governance in the EU

United Kingdom
On 21 May 2003 the European Commission published its Action Plan setting out its priorities for reforming company law and corporate governance in the EU.  The Action Plan, entitled "Modernising Company Law and Enhancing Corporate Governance in the European Union - A Plan to Move Forward", is the Commission's Response to the Final Report from the High Level Group of Company Law Experts (the Winter Report) published on 4 November 2002.  The Action Plan proposes both legislative and non-legislative measures over the short term (2003-2005), medium term (2006-2008) and the long term (2009 and after).

Three months before the collapse of Enron the European Commission set up the High Level Group, chaired by Professor Jaap Winter, to make recommendations on 'a modern regulatory framework for EU company law'.  In particular, the High Level Group focused on what principles should be adopted across the EU in the areas of corporate governance, company formation and capital maintenance, corporate groups and pyramids, and corporate re-structuring and mobility between member states, as well as the question of whether new European-wide entities, such as a European Private Company, should be created.  The review took place against the background of nine existing Directives and one Regulation on EC company law and was carried out at the same time as the various draft Directives designed to implement the Commission's Financial Services Action Plan of 1999 (which include the Market Abuse, Prospectus, Takeover, Transparency Obligations, and Investment Services Directives) continued slowly to progress through the Commission and the European Parliament. 

With the collapse of Enron and the introduction in the US of the Sarbanes-Oxley Act of 2002 in its wake, the Commission has channelled further effort into tackling perceived weaknesses in the way companies in Europe are managed and regulated, whilst at the same time resisting a knee-jerk legislative response along US lines.  The Commission is continuing to try to persuade the US regulators that EC rules are at least equivalent to new US standards and that European companies with US connections should not be subject to all the extra-territorial effects of Sarbanes-Oxley.  The Commission therefore sees the Action Plan as a vital part of rebuilding European investor confidence and of ensuring that companies doing business in the EU are able to do so efficiently and competitively.  In light of this, the two main objectives of the Action Plan are:

  1. to strengthen shareholders' rights and protection for employees, creditors and other parties dealing with companies and to adapt company law and corporate governance rules appropriately for different categories of company; and
  2. to foster the efficiency and competitiveness of business, particularly by breaking down barriers to companies operating across the EU.

Next steps and impact on UK company law

The Action Plan follows nearly all of the key recommendations made by the High Level Group.  It does not have to be approved by the European Parliament or Council, although they will be given the opportunity to comment.  The Plan itself establishes those reforms which the Commission intends to introduce first: where these require legislation which will be binding on member states or companies across the EU (Directives or Regulations), this will have to be drafted after further consultation and approved in the usual way by the Parliament and the Council (which can take several years).  Where member states do not already comply with the terms of a new Directive, further national legislation will be needed to implement the reforms.

In many respects the UK already has in place legislation or corporate governance codes which reflect the principles recommended by the High Level Group for all member states; but in other areas the proposed reforms, if and when introduced, could significantly alter English company law and practice.  Some of these areas are highlighted in the following summary of the Action Plan.

Corporate Governance

The Commission has decided not to try to formulate an EU-wide corporate governance code.  Instead, it believes that the EU should adopt a common approach covering a few essential rules and that it should ensure adequate co-ordination between corporate governance codes. 

In the short term, the Commission proposes to introduce provisions governing:

  • The inclusion in the annual reports and accounts of listed companies of an annual corporate governance statement: this will consist of a coherent and descriptive statement covering key elements of their corporate governance structure and practices; describing the operation of the shareholder meeting and its key powers, and of shareholder rights and how they can be exercised.  For English companies this would entail summarising in the annual report many of the provisions in the articles relating to shareholder meetings and votes, as well as the statutory rights of shareholders to, for example, put resolutions to a meeting, requisition an EGM and remove directors from the board.  The new European proposals will also require disclosure of the composition and operation of the board and its committees; the identity of shareholders with major holdings and their voting and control rights as well as key agreements; any other direct or indirect relationships between these major shareholders and the company; any material transactions with other related parties; the existence and nature of a risk management system; and which national corporate governance code the company complies with, including an explanation of any deviations from it.  These requirements, which go slightly further than those already applicable to UK-listed companies, would be implemented in a Directive.
  •  The exercise of rights by shareholders: the Commission is determined to encourage shareholders in listed companies to exercise their rights: the Transparency Obligations Directive, when implemented (around 2005), will allow listed companies to arrange for information about their business to be communicated to shareholders by electronic means.  In addition, the Commission proposes to create a framework Directive designed to help shareholders in listed companies use their rights to ask questions, to table resolutions, to vote in absentia and to participate in general meetings electronically.  To make these reforms more effective across the EU, the Directive will also tackle the existing legal barriers to cross-border voting, particularly where shares in a company are held through nominees situated in another member state for the ultimate benefit of investors in a third member state.
  • The role of independent non-executive or supervisory directors: the Commission accepts that both the one and two-tier board structures are here to stay, and it believes that the independent non-executive or supervisory directors have an important role to play, especially where executive directors have a conflict of interest, such as on the nomination, remuneration and audit committees of the board.  Contrary to the recommendations of the High Level Group (and the Higgs Review of Non-executive Directors in the UK), however, the Commission thinks that the majority of the nomination committee should be executive directors.  These principles will be set out in a (non-binding) Recommendation to be published in the short-term, which will contain minimum standards for the creation, composition and role of the nomination, remuneration and audit committees, which the Commission would like to see enforced by member states at least on a "comply or explain" basis.  The Recommendation would also specify certain minimum standards of what does not constitute "independence" for a director.
  • Collective responsibility of all board members for financial and for key non‑financial statements: a Directive will be adopted confirming the collective responsibility of directors for such statements, including the proposed annual corporate governance statement.
  • Directors' remuneration: following the recommendations of the High Level Group, the Commission proposes a (non-binding) Recommendation that member states should require listed companies to disclose their remuneration policy and the details of the remuneration of individual directors in the annual accounts, to put share option schemes for directors to prior approval by shareholders, and to recognise in their annual accounts the costs of such schemes to the company.  In the UK these principles are to a very large extent reflected already in the Directors' Remuneration Report Regulations (which came into force last year), in existing provisions of the Listing Rules, and in the draft Financial Reporting Standard (FRED 31) published by the Accounting Standards Board at the end of last year, which envisages that from 1st January 2004 companies will have to recognise the fair value of employee share options as an expense in the profit and loss account (bringing UK GAAP into line with International Accounting Standards).
  • Further reforms to corporate governance: the Commission intends to create a European Corporate Governance Forum to help encourage coordination and convergence of national codes and the way they are enforced and monitored.

In the medium term, the Commission intends to introduce:

  • A special investigation right, whereby shareholders holding a certain percentage of the share capital would have the right to ask the court or administrative authority to authorise a special investigation into the affairs of the company.  In the UK 200 or more shareholders, or those holding 10 per cent or more of the shares in issue, can request the DTI to investigate their company's affairs, although in practice such right is exercised infrequently.
  • A wrongful trading rule, under which directors would be held personally accountable for the consequences of the company's failure, if it is foreseeable that the company cannot continue to pay its debts and they do not decide either to rescue it, ensure payment of the debts or put it into liquidation.  Such a rule exists in some form in most member states (including the UK) but the Commission intends to harmonise the different rules to ensure an equivalent level of protection for creditors across the EU.
  • EU-wide directors' disqualification rules as a sanction for misleading financial and non-financial statements and for other forms of misconduct by directors.  These rules, the special investigation right, and the wrongful trading rule will be contained in a Directive.
  • Flexibility for companies to determine whether they have a one tier system (a board made up of executive and non-executive directors) or two-tier one (with one board of managing directors and one of supervisory directors).  This principle will be contained in a Directive which, if implemented in the UK, would require the Companies Act to permit companies to have a supervisory board structure.
  • Mandatory disclosure by institutional investors of their investment policy and their policy on the exercise of voting rights in companies in which they invest; and mandatory disclosure (on request) to their beneficial holders of how these rights have been used in a particular case.  However, institutions will not be required to disclose to the public or systematically how they have exercised their voting rights: this will be welcomed by UK institutions who fear that if they were made to disclose publicly how they voted in relation to particular companies or issues they could be targeted by special interest groups which are seeking to change particular aspects of a company's policy.  These provisions will be contained in a Directive.

Capital Maintenance and Alteration

In the short term, the Commission intends to adopt the recommendations of the High Level Group and simplify the Second Company Law Directive concerning the formation of public limited liability companies and the maintenance and alteration of their capital.  Proposed amendments would:

  • Relax the requirement (currently reflected in the UK in section 103 of the Companies Act 1985) for public companies to obtain an expert valuation of contributions in kind.
  •  Reduce the scope of the prohibition on a company giving financial assistance in connection with the acquisition of its own shares (section 151 of the Companies Act).  In last year's White Paper on the reform of company law the UK Government indicated that it intends to remove the prohibition for private companies, but its relaxation for public companies will require the EU Second Company Law Directive to be amended.  The High Level Group recommended that public companies should be allowed to give financial assistance to the extent of their distributable reserves, subject to shareholder approval.
  • Allow public companies to acquire their own shares within the limits of their distributable reserves (in the UK this is already permitted).
  • Relax the requirement for shares in a public company to be issued on a pre-emptive basis.  In the UK, section 89 of the Companies Act places such restrictions on all companies, and public companies whose shares are listed are also subject to pressure from institutional shareholders to comply with guidelines laid down by their Investment Committees on the percentage of share capital that can be issued on a non-pre-emptive basis.  Even if further exemptions to section 89 were to be created, institutions could be expected to continue to pressurise listed companies to comply with such guidelines.
  • Introduce 'squeeze-out rights', under which the holder of a large majority of a company's securities could compel minority shareholders to sell their holdings at a fair price, and 'sell out rights' permitting minority shareholders to compel the holders of a large majority of the share capital to purchase their holdings at a fair price.  These proposals go further than the draft Takeover Directive, which will give such rights only to shareholders in a listed company which is the subject of a takeover.  In the UK, sections 429 and 430A of the Companies Act provide such rights in a takeover situation; in the case of private companies, the sort of 'drag' and 'tag' along rights often included in the articles of association or shareholders' agreement would become enshrined in statute.

The Commission also proposes to launch a feasibility study in the medium term into an alternative regime based not on maintenance of capital rules but on a requirement to meet a solvency test before any payment of a dividend or other distribution.  Such a regime is operated in New Zealand, for example, where directors must determine whether or not a distribution can be made principally by reference to the ability of the company to satisfy a solvency test (based on liquidity and balance sheet solvency) immediately after the distribution is made.  Rather than maintaining a narrow focus on the company's realised profits (to the extent not already distributed or capitalised) less its realised losses (to the extent not properly written off) accumulated over the life of the company, the solvency test requires an assessment of the company's financial position and prospects (at the time of the distribution) as if the distribution were made.  As well as the payment of dividends, the test is used in relation to repurchase or redemption of shares, any provision of a discount to a shareholder or reduction in a shareholder's liability, and the giving of financial assistance.  The use of a solvency test renders unnecessary many of the complex rules for maintenance of capital - such as those relating to financial assistance, reductions of capital, the prohibition on issuing shares at a discount, and the need to create capital redemption reserves and the like - that are required in the UK and other 'capital maintenance' countries.  A solvency-based regime is therefore thought to have the advantages of being both simpler to administer and of providing greater protection to creditors and other stakeholders.

Groups and Pyramids

Groups of companies, common in most member states, are thought to present risks for shareholders and creditors.  In the case of listed companies, a proposed new Directive, and the Regulation on international accounting standards adopted in July last year, will compel listed companies from around 2005 to disclose more information about the structure of the group and intra-group relations (eg the extent to which a subsidiary is dependent on its parent company to continue trading), which will reduce the risks to creditors.  For groups where the parent company is not listed, the Action Plan recommends the introduction in the short term of more comprehensive financial and non-financial disclosure obligations.

In the medium term the Commission plans to introduce a framework Directive requiring member states to allow the directors of a subsidiary company to adopt and implement a co-ordinated group policy in priority to the interests of their particular company, provided that its creditors are adequately protected and there is a fair balance of burdens and advantages over time for the company's shareholders.  In the UK and some other member states the introduction of such a principle would require a significant change in the law relating to directors' duties (which are owed pre-eminently to the individual company): the change might well be welcomed by groups, and particularly by directors of subsidiaries who, in spite of owing their duties to their own company, often feel compelled by commercial factors to have regard to the interests of their parent and the group as a whole in making their decisions.

Pyramid structures, defined by the High Level Group as 'chains of holding companies with the ultimate control based on a small total investment, thanks to the extensive use of minority shareholders', are hardly ever used in the UK but are relatively common in some other member states.  Indeed it has been estimated that the majority of listed companies in the EU are owned through pyramid structures: in Scandinavia, for example, the structure is sometimes used where the company is ultimately controlled by a family or individual.  The Commission is concerned that the lack of transparency in such structures can lead to non-controlling shareholders being prejudiced, and intends to consult further on how such abuses may best be tackled.  The Commission seems likely, however, to meet heavyweight opposition to any proposals for significant change.

Corporate Restructuring and Mobility

At present, one of the greatest barriers to businesses operating across Europe is the lack of a 'passport' system under which a corporate entity established in one member state can transfer itself to another member state.  A company incorporated in England and Wales, for example, is a creature of English company law and, although it can of course do business in France (whether or not through a branch), it cannot transform itself into a French company or 're-incorporate' itself under French law.  Moreover, an English company cannot without court approval 'merge' into another corporate entity (such as a French company) to form a new entity or with only one surviving (as is possible under Delaware law and the law of some EU member states).  One option would be to incorporate a separate French company.

Further problems are also caused by conflicts between the laws in different member states and the question of which state has jurisdiction over the rights and obligations of a company incorporated elsewhere but operating in a particular member state.  The conflict between the so-called 'real seat' doctrine favoured by Germany and some other member states (which holds that a company's governing law is determined by its actual seat of administration) and the 'incorporation' doctrine favoured by the UK, Holland and others (under which a company's governing law is determined by the country in which it was incorporated) came to the fore recently in the ECJ's ruling in the Überseering case (covered in a separate LawNow).  Whilst in that case the ECJ found a German law based on the real seat doctrine to be incompatible with EC law, on another level the case serves as a reminder of the many obstacles to companies' freedom of establishment and freedom of movement of capital which remain across the EU, and that member states are likely to fight to preserve many of them.

To address this, the Commission intends to introduce a new Directive aimed at facilitating mergers between companies from different member states by requiring member states to harmonise their laws on mergers (perhaps so that all member states would have to permit a Delaware-type of merger out of which would emerge a single surviving entity).  A second Directive, aimed at facilitating the cross-border transfer of a company's seat, is also planned for the short term.

Given the significant differences between the laws of different member states, and the need to resolve related issues such as tax, board structure and employee participation, it seems probable that the proposed Directives will make slow progress and could even stall completely (a predecessor draft Directive was withdrawn 16 years after first being proposed).  For example, in the White Paper, the UK Government stated expressly that it does not intend to introduce new rules to allow companies to move from one company law jurisdiction to another, because of the tax revenues which it expects to lose if such rules were created.  Other member states are likely to have similar concerns.

An alternative to cross-border mergers is the concept of a European company able to operate and be legally recognised in all member states.  The Commission has already approved (in October 2001) a European Company Statute which allows the creation of the "Societas Europaea" (SE).  However, the SE is not expected to be much used by SMEs, and the Commission is therefore going to investigate the feasibility of creating a 'European Private Company' (EPC) for use primarily by SMEs.

Similarly, the Commission is to commence new or progress existing initiatives to create other forms of pan-European entity, such as a European Co-operative Society, European Association and European Mutual Society.

Action Plan on Statutory Audit

At the same time as the Company Law Action Plan, the Commission published ten priorities for improving and harmonising the quality of statutory audit throughout the EU, designed to ensure that investors and other interested parties can rely fully on the accuracy of audited accounts and to prevent conflicts of interest for auditors.

The main driver for the proposals is the development of the single European capital market with 7,000 listed companies and the continued efforts to harmonise and improve the two million or so statutory audits that are conducted annually in the EU.  The Commission intends that a legally underpinned comprehensive audit regulatory and supervisory environment in the EU will be at least equivalent to the regulatory systems currently being implemented by the US Public Company Accounting Oversight Board.  As such, it envisages EU auditors being exempt from the onerous US regulatory requirements.

Short term priorities are as follows:

  •  modernisation of the 8th Company Law Directive to ensure a comprehensive, principles-based Directive applicable to all statutory audits conducted in the EU;
  • reinforcement of the EU's regulatory infrastructure by the creation of an Audit Regulatory Committee;
  • strengthening public oversight of the audit profession by the development of minimum requirements for public oversight; and
  • requiring international standards on auditing for all EU statutory audits (including, inter alia, development of an endorsement procedure, a common audit report and high quality translations).

In the medium-term the Commission proposes to introduce:

  • improved disciplinary sanctions with co-operation between member states on cross border cases;
  • improved transparency on audit firms and their networks;
  • strengthened corporate governance with more effective audit committees and internal controls;
  • reinforced auditor independence and code of ethics;
  • a deepening of the Internal Market for audit services by removing restrictions in the 8th Directive on ownership and management of audit firms; and
  • a study of the economic impact of auditor liability regimes.

For copies of the Commission's Action Plan, the related press release and FAQs, and the High Level Group's Final Report, click here.

For copies of the Action Plan on Statutory Audit and related press release and FAQs, click here.

For a copy of the current status of the various initiatives under the Financial Services Action Plan, click here.

For further information please contact Leonie Counihan (Corporate Assistant) by telephone on +44 (0)20 7367 2924 or by e-mail at leonie.counihan@cms-cmck.com or Peter Bateman (Corporate Professional Support Lawyer) by telephone on +44 (0)20 7367 3145 or by
e-mail at  peter.bateman@cms-cmck.com .