Companies and their employees

... leaving the factory!All company law students know about the case of Salomon v Salomon & Co Ltd, even though it dates from 1897. The case continues to be a leading authority for the key company law concept that companies are separate legal entities, and is an early example of shareholders avoiding any liability when a company went into insolvent liquidation. Saloman & Co Ltd had been incorporated under the Companies Act 1862, the first of many Companies Act and a consolidation of, among others, the Joint Stock Companies Act 1844.

Before the Joint Stock Companies Act 1844 companies could only be formed by an act of Parliament or Royal Charter. These pre-1844 companies were generally unlimited liability corporations. Only where there was a significant public interest were companies granted the privilege of the protection of limited liability. This was often the case for transportation (particularly railway) or utilities’ companies, where large capital investment was required and where there was likely to be substantial public benefit. However, the Limitation of Liability Act 1855 made this privilege a right for any company incorporating under the 1844 Act, where the shareholders paid up £50 share capital (approximately £5,000 in 2013 terms).

There had been wide debate about limited liability corporations, with a Royal Commission taking evidence on the issue and deciding against limited liability being introduced into any company law reform (Royal Commission on the Mercantile Law, Report 1854). However, the new coalition government of 1855, led by Lord Palmerston  appears to have rushed through the 1855 Act under the political and financial pressure of dealing with a failing and unpopular war, the Crimean (see Colin Mackie’s analysis at From Privilege to Right: Themes in the Emergence of Limited Liability). It should not be a surprise that the immediate beneficiaries of limited liability were the upper and middle classes. It was even recognised that lawyers and accountants would gain new business from advising on the use of the new limited liability structures.

Some arguments against joint stock companies with limited liability came from respected sources. In Book V of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, he makes observations that are as relevant today, with directors of FTSE100 companies arguably awarding themselves excessive remuneration whilst taking, in the case of financial institutions in particular, outrageous risks, without active shareholder control:

The trade of a joint-stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of these proprietors seldom pretend to understand any thing of the business of the company; and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half yearly or yearly dividend as the directors think proper to make to them. This total exemption front trouble and front risk, beyond a limited sum, encourages many people to become adventurers in joint-stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks, than any private copartnery can boast of. The trading stock of the South Sea company at one time amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds. The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account, that joint-stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege; and frequently have not succeeded with one. Without an exclusive privilege, they have commonly mismanaged the trade. With an exclusive privilege, they have both mismanaged and confined it.

This is all background. The essential point is that we have become so used to the idea of a limited company being considered to be a separate legal entity with limited liability that we have forgotten how unusual this is, and what an artificial mechanism has been created in order to encourage investment in business, and to protect investors should their investment not prove successful. It is as if we have collectively decided that the interests of the capital classes are completely paramount, with no regard for the wider social and societal interests in companies being good employers.

In my view, we have not ensured that this shareholders’ “right” to limited liability, as Colin Mackie identifies it, is balanced by adequate shareholder “responsibilities” to protect the public interest.

I remember being disappointed during one of my first readings of the Companies Act 1985 (which was the relevant law at the time) that the only statutory duty directors owed to employees, as set out at section 309, was so limited. Directors had only to “have regard to  interests of employees”, but crucially these employees had no mechanism to enforce the provision.

This continues to be the case under the current Companies Act 2006. This relatively new law is a major reform and consolidation of UK company law. It extends to 1,300 sections and 16 schedules, making it one of the longest acts of Parliament in UK history. Part of the Act put directors’ duties on a statutory footing for the first time – see Companies Act 2006, Part 10, Chapter 2. However, nowhere in these duties are employees given adequate protection. Section 172 of the Companies Act 2006 merely reiterates the “having regard to” wording used in the Companies Act 1985, but this is still subservient to the interests of the members (shareholders).

How radical would it be, in practice, if shareholders were required to recognise the benefit of being granted limited liability protection by accepting that their interests were not paramount? What if Section 172 read as follows (changes in red):

172  Duty to promote the success of the company

(1)  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

(a)   its members as a whole, and

(b)   the company’s employees.

(2)  A director of a company, must, for the purposes of subsection (1), 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,

(bc) the need to foster the company’s business relationships with suppliers, customers and others,

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

(de) the desirability of the company maintaining a reputation for high standards of business conduct, and

(ef)  the need to act fairly as between members of the company and the company’s employees.

(2)  Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members and the company’s employees, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members and the company’s employees were to achieving those purposes.

(3)  The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

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Shareholders, Directors and Bonuses

As the informal lawyer to my group of fellow commuters on the 0634 from Havant to Waterloo, I was asked yesterday to explain why directors of the Royal Bank of Scotland plc (RBS) might consider it necessary to resign if they were not permitted to pay what appears to the general public to be obscene levels of bonuses.  The answer lies in the codified version of the old common law that directors owe a duty to act in the best interests of their company.

Under s.172 of the Companies Act 2006 directors have a duty to promote the success of the company, with six factors to consider set out at s.172(1).  One of these factors includes acting fairly as between shareholders (s.172(1)(f)).  Where one shareholder demands a particular course of action that in the opinion of the directors is not best suited to promote the success of the company or disadvantages another class of shareholders, they can claim to be put in a difficult position.  The demand by HM Treasury for control over the RBS 2009 bonus pool as a condition of RBS entry into the Governments Asset Protection Scheme is arguably such a course of action, if you consider that the lack of bonuses will lead to the inability of RBS to retain and motivate high performers amongst its staff, so damaging its success and the share value for those minority shareholders not demanding direct control over bonuses.

However, the directors would have no difficulty if they were compelled by a shareholders’ resolution to act in a particular way.  In particular, if the Articles of the company dictated a bonus policy on the company, the directors would be bound to follow the policy or risk derivative action by the shareholders.  In the case of RBS, HM Treasury initially held 70.3% of its shares through UK Financial Investments Limited.  It now holds an 84% economic interest in RBS following RBS’ entry into the Asset Protection Scheme, but the Government has no more than 75% of the shareholders’ votes (otherwise RBS would be required to delist).

It therefore remains open for the Government to call an extraordinary general meeting of RBS shareholders (as it owns more than 10% of the shares, it can demand that the directors call an EGM under s.303 of the Companies Act 2006), and table a special resolution to amend the Articles accordingly (s.21(1); this will need 75% vote (s.283)).  The EGM would be the required route as only private companies can resort to written resolutions under the Companies Act 2006 (s.281(2)).