Enlightened shareholder value: anxious directors

The new Companies Act is a wide-ranging reform of the core legislation which governs every significant UK business entity. One of the most significant changes introduces the concept of 'enlightened shareholder value', thereby reflecting social change in the last 15 years. These provisions are likely to come into force in October 2008.

The all encompassing concept of corporate social responsibility will now no longer be entirely elusive and abstract. Instead, directors will have new duties and obligations in this respect. If the many high profile “social” issues which face the food industry, such as provenance, ethical trading, local sourcing, obesity and supplier relationships, will mean that directors of companies within the food sector will be particularly affected by the so-called “enlightened shareholder value” concept. At present, however, directors are more apprehensive than enlightened by the prospective changes.

Chapter 2 of Part 10 of the Act contains the controversial new directors’ duties. The very fact that the Act contains anything at all on this area is itself controversial. For the first time, the duties of directors will be written down in the statute book. Codification will supersede the general fiduciary duties which have been formulated through the British courts ever since the first Companies Act in 1862. So, the general common law duties for directors – to act bona fide and in the best interests of the company; not to make personal profit; not to put themselves in a position of conflict – are to disappear, replaced by seven sections of the Companies Act.

A new key section will be Section 173, which reads as follows:

173 Duty to promote the success of the company

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to –

(a) the likely consequences of any decision in the long term,

(b) the interests of the company’s employees,

(c) the need to foster the company’s business relationships with suppliers, customers

and others;

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of

business conduct, and

(f) the need to act fairly as between members of the company.

It is the importance and significance attached to the wider ranging factors in (a) to (f) above (CSR Factors) that has fuelled the debate during the latter stages of the Bill. Whereas the common law fiduciary duties which have preceded the codified duties are general and therefore somewhat nebulous, and certainly flexible, these codified duties and the CSR Factors are to be written in tablets of stone.

What does this mean for directors in the food sector?

Any company that is involved in manufacturing, sourcing or selling a product or its ingredients in the food chain knows the importance of fostering the company’s business relationships with suppliers and customers; the impact of the company’s operations on the community and the environment and the desirability of a reputation for high standards of business conduct. These and many other aspects contribute to “success” in any case; but it is one thing for directors to achieve or seek to achieve success for their investors in the way they choose using their business judgement, and quite another for directors to have legal duties and obligations to “have regard” to the CSR Factors. Breach of the legal duty means a director can be sued personally. The success of a company will now mean more than just maximising profits.

Directors of companies in the food sector are only too aware of the importance to their business of the CSR Factors. It is easily arguable that they drive business value, but they definitely feature in any risk management exercise. At the very least, the costs of getting it badly wrong are enormous (one only has to consider what organisations such as Nike or Chiquita have had to do to change their public perception of a few years ago). The uncovering of one major incident or alleged unethical strategy can have an effect which is both instant and measurable for investors in the company.

The enshrining of the enlightened shareholder value provisions in Section 173 of the new Companies Act is not the only reason for directors to be more concerned about their personal liability. There are changes in the new Act which make them easier litigation targets for a wider group of people.

Directors owe their duties to the company itself. Historically, case law has governed how and when companies are able to bring so-called derivative actions against their own directors – and they have been complex and uncertain. Nobody could advise with particular certainty when and where such a claim could be made.

Part 11 of the new Companies Act introduces a new process for bringing derivative actions. Although there will be safeguards against unwarranted or frivolous claims, directors should be concerned about how the process will be operated. The existence of a new special process means that somebody is likely to exploit it. Just at the time that activist shareholder groups are honing and developing their techniques to gain maximum influence, a new derivative claims process can be exploited to test the range of these new and specific directors’ duties which are enshrining the so-called enlightened shareholder value. Directors beware.

More specifically, any member can bring the derivative claims. They do not even have to be members at the time of the alleged breach of duty. The claim can be in respect of not only an actual, but also a proposed, act or omission constituting negligence or breach of the directors’ duties – therefore an unethical course of conduct or implementation of a particular unethical sales strategy might make the directors vulnerable.

Quite apart from this new threat of personal liability for a director, single issue activists can cause great reputational damage to companies. The new Act will contain significant barriers aimed at preventing undeserving claims. In particular, before any such action is launched, the court will need to be convinced that the claimants have a prima facie case (on risk of cost or other sanctions). The court will also take into account the evidence of interests and views of the silent majority of shareholders (or allow the company to gauge it).

So what effect will all these changes have on the corporate governance of companies in the food sector?

During the course of the Companies Bill, the opposition consistently expressed concern that directors’ business judgment made in good faith could be second guessed as a result of these enshrined shareholder value provisions. Furthermore, to head off this concern there would need to be a paper trail to demonstrate directors’ “regard” for the CSR Factors.

Whilst the Government has been making light of these concerns, it was also warding off other organisations such as the Trade Justice Movement, Christian Aid and War on Want, which sought a stronger and more direct form of duty on directors to take into account the CSR Factors.

If a private company became insolvent due to, for instance, a contaminated product scandal, the liquidator might scrutinise the company’s governance to assess the “regard” that the directors had for the relevant CSR Factors. But it is listed public companies and their directors who will be most affected. The vast majority, if not all, UK public listed companies will feel that it is motherhood and apple pie that they must have regard to all the CSR Factors in order to be successful. As from October 2008, however, the directors may be personally liable if they have not.

As a result, public companies in the food sector may look to align and supplement their existing procedures so as to match the CSR Factors expressed in Section 173(1) of the new Act. We may see the emergence of the “Community and Environment” committee, the “Business Relationship” committee and the like.

Somebody is going to try out the new system. Food companies, never far from the public gaze, and very accessible to the consumer by the nature of their products, will be in the firing line if their products feature in the next food or environmental scandal. And this time it could get personal for the directors, especially if shareholder value is affected.

This article first appeared in the Food & drink bulletin in November 2006. Please click here to view the pdf in a new window.