What sanctions are necessary?

In recent years, some commentators have concluded that a greater emphasis on criminal rather than civil sanctions would improve compliance. Others have suggested the introduction of a business judgment rule to be applied by the Courts, similar to that which exists in the US, in assessing not only breach of duty but also the seriousness of that breach and therefore the severity of any sanction. Some have also proposed a codified statement of the sanctions available, similar to that contained in the 2006 Act in respect of directors’ duties.

The 2006 Act does not take account of these suggestions – it specifically reaffirms the existing sanctions applicable under the common law. It is considered that, on balance, this is the correct approach. An analysis of the case law tends to support the view that the variety of sanctions available is adequate to compensate victims, punish guilty directors, act as a deterrent and generally foster compliance. In the current climate, it is clear that this area of the law plays an important, but not disproportionate, part in the Virtuous Circle.

The sanctions: shareholder and market pressure – power in the hands of the owners

Shareholders and their agents

In the Virtuous Circle, a further key segment is governed by shareholders or their agents through the form of codes and guidelines including, centrally, the Combined Code.

It is obvious that codes and guidelines are fundamentally different from law and regulation in both concept and effect. Nonetheless, it is an important distinction which has a profound effect on behaviour and approach. So, in the context of the Virtuous Circle and in contrasting the shareholder and market pressure segment with the law and regulation segment, the key question must be: do codes and guidelines work? Do they exert sufficient pressure on boards to guarantee sufficiently high standards of governance? Would it be more effective to have law or regulation instead?

It is suggested here that codes and guidelines do have a key role to play in the Virtuous Circle and, in some of the central areas of governance, are preferable to law and regulation. It is important to recognise that shareholders should have a central role to play in judging what is right for their company on governance issues. Ultimately, shareholders can impose sanctions on boards or individual directors if they wish to intervene because of concerns regarding their behaviour or decisions. Therefore, the argument in favour of codes and guidelines (and against law and regulation) in the central areas covered by the Combined Code is a powerful one.

The investment community in the UK, dominated as it is by insurance companies, pension funds and other institutional shareholders, has been at the

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heart of the debate about corporate governance. They and their agents were prominent well before the 1992 Cadbury Report.35

Since 1992, it is clear that individual shareholders have become more active in upholding governance standards. As owners, it is also clear that they should claim a key role in ensuring that the companies in which they invest are governed to the standards which they consider to be appropriate and which ultimately help to support, in the widest sense, the efficiency and durability of capital markets.

The Virtuous Circle, as it now exists, also includes a number of agents for shareholders: representative bodies which, on behalf of their members, helped to contribute to the creation of the Combined Code and to a variety of best-practice guidelines. Those agents also help to police day-to-day compliance. The agents specifically mentioned in the Virtuous Circle include ABI, NAPF and IMA, which, together with the AIC, are the members of the Institutional Shareholders’ Committee. That Committee has itself revised its statement regarding the responsibilities of institutional shareholders and their agents (see ‘What sanctions apply under the codes and guidelines’ below).

So, in this important segment of the Virtuous Circle, the presence of shareholders and their agents, bringing pressure on boards to comply with governance standards, is entirely appropriate.

Codes versus law and regulation

It is arguable that the issues covered, for instance, by the Combined Code should instead be covered by regulation in order to ensure compliance, as contrasted with the comply-or-explain principle of the Combined Code. Law and regulation would provide clear penalties for breaches by boards or individual directors and would thus underwrite compliance. So why not simply transfer all compliance issues within the Combined Code to law and regulation and ensure that companies comply?

The answer lies, in part, in the Cadbury Report, which laid the foundation for the Combined Code and provides authoritative support for the comply-or- explain approach.

We believe that our approach, based on compliance with a voluntary code coupled with disclosure, will prove more effective than a statutory code. It is directed at establishing best practice, at encouraging pressure from shareholders to hasten its widespread adoption, and at allowing some flexibility in implementation. We recognise, however, that if companies do

35Sir Adrian Cadbury’s Committee on the Financial Aspects of Corporate Governance (December 1992). Indeed, that 1992 Report acknowledges a number of ‘relevant published statements’ which include, for example, the Institutional Shareholders’ Committee: ‘The Role and Duties of Directors – A Statement of Best Practice’ (April 1991) and PRONED: ‘Code of Recommended Practice on Non-Executive Directors’ (April 1987).

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What sanctions are necessary?

not back our recommendations, it is probable that legislation and external regulation will be sought to deal with some of the underlying problems which the report identifies. Statutory measures would impose a minimum standard and there would be a great risk of boards complying with the letter, rather than with the spirit, of their requirements.

The Combined Code itself is underpinned by the Listing Rules which, arguably, go some way towards regulation in that, ultimately, there are sanctions for noncompliance with the Listing Rules (see ‘What sanctions apply under codes and guidelines’ below). However, in real terms, the Combined Code (supported by the Listing Rules) upholds the approach, favoured by the Cadbury Committee, of a ‘voluntary code coupled with disclosure’.

The comply-or-explain approach has the following advantages:

(Crucially) flexibility enables the different circumstances of a broad range of companies to be accommodated, as long as the explanations for any non-compliance satisfy the shareholders.

The focus is on shareholders and their agents to assess the explanations given by individual companies and respond if required. The Cadbury Committee took the view that it was appropriate for the issues covered by the Combined Code to be policed by shareholders rather than the regulators.

The response of companies to a code is likely to be more constructive since there is a concern that companies will tend to ‘comply with the letter, rather than with the spirit’ of law or regulation.

Arguably, the Combined Code imposes a lighter burden on companies than would be the case with law and regulation which, in a number of instances, would require audit trails of compliance, and indeed compliance would ultimately have to be an issue of relevance to external auditors.

Companies that do not comply with statutory or regulatory requirements face serious sanctions and, in addition, damage to their reputation through adverse press comment. So the reality is that boards will comply with legal or regulatory requirements to avoid such sanctions. The problem, however, is that because of the serious nature of those sanctions, legislation and regulation need to be precise, need to define the prescribed action or omission and normally operate on a one size fits all basis.

Over time, provisions may be moved from the Combined Code into law or regulation. The public outcry over excessive levels of remuneration ultimately led to the Remuneration Regulations. In addition, the effect of EU Directives and the process of harmonisation of company law across the EU will, eventually, create legislation on some issues currently covered by the Combined Code. However, the question arises: ‘Is that progress?’ Probably not. Take, for

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example, the European Commission’s Directive on statutory audits of annual and consolidated accounts36 (Audit Directive). Article 41 provides that each public interest entity (which includes UK listed companies) must have an audit committee and the Directive goes on to provide that: ‘At least one member of the audit committee shall be independent and shall have competence in accounting and/or auditing.’ Real concerns have been expressed about the consequences of Member States legislating to implement the provisions of this Directive. Among those concerns are issues about definition and the clear potential for loss of flexibility for companies owing to the fact that:

A statutory definition of ‘independence’ would be required – effectively replacing (in the context of audit committees) the current Combined Code guideline on independence. That, in turn, will mean that boards may no longer be entitled to form a judgement abut the independence of a director, and shareholders would cease to be the arbiters of boards’ decisions in that context.

A statutory definition will also be required for ‘competence in accounting and/or auditing’.

So the likely result will be less flexibility, with no ability for boards to present any alternative solution to shareholders, if a board considers that the regulation is not appropriate to its particular circumstances.

What sanctions apply under codes and guidelines?

As mentioned above, the Combined Code is underpinned by the Listing Rules. Even though it is not described as a disciplinary measure by the FSA, the ultimate sanction for non-compliance with any Listing Rule is, at least in theory, the FSA suspending or cancelling a company’s listing. Much more relevant to the concept of enforcement of the Combined Code is shareholder power which, in various ways, can ensure compliance. In September 2005, the ISC revised the publication37 in which it describes the circumstances where shareholders and/or agents might intervene and the actions which might be considered.

Instances when institutional shareholders and/or agents may want to intervene include when they have concerns about:

the company’s strategy;

the company’s operational performance;

the company’s acquisition/disposal strategy;

independent directors failing to hold executive management properly to account;

internal controls failing;

36Directive 2006/43/EC.

37‘The Responsibilities of Institutional Shareholders and Agents – Statement of Principles’.

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What sanctions are necessary?

inadequate succession planning;

an unjustifiable failure to comply with the Combined Code;

inappropriate remuneration levels/inventive packages/severance packages; and

the company’s approach to corporate social responsibility.

If boards do not respond constructively when institutional shareholders and/or agents intervene, then institutional shareholders and/or agents will consider on a case-by-case basis whether to escalate their action, for example, by:

holding additional meetings with management specifically to discuss concerns;

expressing concern through the company’s advisers;

meeting with the Chairman, with senior independent director, or with all independent directors;

intervening jointly with other institutions on particular issues;

making a public statement in advance of the AGM or an EGM;

submitting resolutions at shareholders’ meetings; and

requisitioning an EGM, possibly to change the board.

In addition, it is now best practice for companies to include vote-withheld boxes in proxy appointment forms. The revised Combined Code in 2006 included a new provision as follows:

For each resolution, proxy appointment forms should provide shareholders with the option to direct their proxy to vote either for or against the resolution or to withhold their vote. The proxy form and any announcement of the results of a vote should make it clear that a ‘vote withheld’ is not a vote in law and will not be counted in the calculation of the proportion of the votes for and against the resolution.

In effect, a vote withheld is an indication of a shareholder’s dissatisfaction on the issue and, in some cases, can be seen as a ‘yellow card’.

The more extreme examples of the above sanctions are, of course, shareholders submitting resolutions at general meetings or requisitioning an extraordinary general meeting (EGM). English company law provides clear rights for shareholders in this context:

shareholders can requisition a company (at the expense of the requisitionists) to give notice of a resolution to be moved at the next annual general meeting and to circulate a statement from the shareholders who make the requisition, for example, to consider an issue of non-compliance with a provision of the Combined Code or to seek to remove one or more members of the board;

shareholders can requisition an EGM for similar purposes;

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