Directors’ duty is not just to investors: There is too much focus on noise in markets and not enough to operational performance

June 4, 2013 6:10 pm

Directors have a duty beyond just enriching shareholders

By John Kay

There is too much focus on noise in markets and not enough to operational performance

Do companies have a duty to their shareholders to minimise the amount of tax they pay? Even if this involves engaging in complex and artificial schemes that shift profits to jurisdictions in which little or no tax is payable?

Under the 2006 Companies Act, directors of British companies are required to promote the success of the business for the benefit of its members (the shareholders). In doing so, they must have regard to six specific factors: the long-term consequences of their decisions, the interests of employees, relationships with suppliers and customers, the impact of corporate activities on the community and the environment, the company’s reputation for high standards of business conduct and the need for fairness between different members of the company.Common tax avoidance strategies that are currently the cause of much debate and criticism involve paying interest or royalties to a company based overseas with a common parent but that may have little operational reality, or booking offshore a transaction that substantively takes place in the UK. Some people might struggle to see how these transactions promote the success of the UK company at all. But the further – and implausible – claim is not just that companies may do these things, but that they are obliged to do them.

British law might have said that the duty of directors is simply to promote the interests of the company’s members. But it doesn’t – and that is no accident. The present formulation – sometimes described as enlightened shareholder value – intentionally struck a middle course between those who argued that the law should simply say that the job of directors was to make lots of money for shareholders, and those who favoured a broader – stakeholder – view of the role of the corporation.

The compromise adopted imposes the duty to promote the success of the company, for the benefit of the members. The obligation of the board is to the company, and if its duties to the company are faithfully discharged the members of the company will profit from the success of the company. In reality, that is how most directors, and almost all directors of successful businesses, think about their roles. They aim to make the company prosper and grow, chiefly for the benefit of its members.

But the list of factors appended to the core statement of duties is designed to rule out arguments of the kind: “However much we might regret the effect of our actions on the welfare of employees, or the effect on the environment, or the impact on our reputation, our obligation is to maximise returns to our shareholders.” The argument that says “however distasteful tax avoidance must be, we have to engage in it” falls at the same hurdle. When companies adopt tax-avoidance measures, it is not because they must, but because they choose to do so.

The legal position differs from country to country, although in practice not by much. In an important recent book, Lynn Stout argues that US law is actually less friendly to shareholder interests than that of the UK. British law and practice is much more supportive of shareholder rights on matters such as pre-emption, board elections and poison pills and less ready to protect incumbent management.

When the UK business department asked me recently to review the effect of equity markets on long-term decision-making in British business, I came to the conclusion that its existing law was perfectly adequate. (I should also disclose my past membership of the Company Law Review Steering Group.) Directors are not only entitled, but required, to look at the effect of their decisions on the long-term success of the company. They are not entitled, far less required, to think that getting the share price up is either necessary or sufficient.

British business gives too much attention to meaningless noise generated in financial markets and not enough attention to improving the operational performance of the company. But directors do that in spite of, not because of, the law. At the moment, they feel insufficiently able to withstand pressure from securities markets to do things that are not in the best long-term interests of the business they run. Perhaps they are discovering that aggressive tax avoidance may fall into that category.