Nov 16, 2017

Since the U.S. Supreme Court handed down its controversial Citizens United decision, the concept of corporate personhood has been highly controversial in the United States.^[1] Yet, despite the ongoing controversy, it has long been settled law that corporations have most—but not all—of the rights and powers of natural persons.^[2] One exception to that general rule, however, is that only natural persons may serve as directors of a corporation.^[3] The same is true in most other major capitalist economies.^[4]

Until recently, however, the United Kingdom stood as a glaring exception to the general rule. For over a century, U.K. company law allowed a corporation or other legal entity to serve on the board of directors of another company.^[5] In 2015, however, Parliament approved legislation containing a ban—albeit allowing some yet to be defined exemptions—of corporate directors.^[6] As of this writing (fall 2017), the ban has not been implemented, but it was expected to come into force soon.^[7]

This Article argues that there are legitimate reasons for companies to use corporate directors. In work done elsewhere with University of Chicago Professor of Law Todd Henderson, I propose that U.S. law be modified to permit legal entities to serve as corporate directors.^[8] That proposal is intended to permit the rise of service companies—so-called Board Service Providers (BSPs)—that would serve on or, preferably, as a company’s board of directors.^[9] In our view, BSPs offer a number of advantages over natural persons as directors.^[10] This is not an appropriate forum in which to rehash those arguments. For present purposes, suffice it to say that if the U.K. ban goes forward, the U.K. would be foreclosing the opportunity for its companies to experiment with the BSP model. In addition, even where the corporate director is not a specialist BSP, but rather a normal business company, there are still advantages to allowing corporations to serve as corporate directors.^[11]

This Article also evaluates the reasons offered for restricting corporate directors to natural persons and finds them wanting. It therefore proposes that the U.K. government either repeal the relevant legislation or, at least, be liberal in granting exemptions to the natural person restriction. Part I briefly traces the history of corporate directors under U.K. law. Part II argues that there are several legitimate reasons for companies to use corporate directors. Part III summarizes the arguments advanced in favor of the legislation restricting the use of corporate directors. Finally, Part IV critiques those arguments.

I. Corporate Directors Under U.K. Law

Prior to 2006, the U.K. had no restrictions on the appointment of a corporation as a director of another company.^[12] As a widely cited 1907 Chancery Division decision explained, for example, under the Companies Act of 1862 there was “nothing ... which in any way ma[de] it incumbent on a company ... to have directors who shall be individual persons and responsible as individuals to the shareholders.”^[13] This remained the rule for the next century.^[14]

The corporate director option apparently was rarely used, although the exact numbers are difficult to find. A 2013 survey of U.K. companies found that approximately 38,000 companies (1.2 percent of all U.K. companies) had one or more corporate directors.^[15] In contrast, however, a 2014 government report found 67,000 companies with corporate directors (2.1 percent of all companies).^[16] In either case, the majority of companies with one or more corporate directors were nonpublic and small in size,^[17] presumably because stock exchange listing standards effectively require directors to be natural persons.^[18]

Recent changes in U.K. company law likely will result in a substantial decline in the number of corporate directors, if not their complete abolition. Since the adoption of the Companies Act of 2006, U.K. law has required that a company “have at least one director who is a natural person.”^[19] This provision was understood to permit corporate directors to continue serving on company boards, but only so long as at least one board member was a natural person.^[20]

The status of corporate directors underwent a further restriction in 2015 with passage of the Small Business, Enterprise and Employment Act (SBEEA), which amended the Companies Act to provide that “[a] person may not be appointed a director of a company unless the person is a natural person.”^[21] Existing non-natural person directors of U.K. companies originally were to be phased out by October 2017, but in September 2016 the U.K. government indefinitely postponed implementation of the ban.^[22] It did so for the government to consider permitting exceptions in limited circumstances, as authorized by the statute.^[23] As of this writing (fall 2017), the government had not yet defined the scope of such exceptions or the situations in which they will be granted, but action was expected in the near future.

II. Why Do Companies Use Corporate Directors?

Interestingly, a survey of fifty-five companies having at least one corporate director reported that “31% saw no advantage to having one, and 11% responded that they did not know what the advantages of having one were.”^[24] While the small size of the sample relative to the tens of thousands of U.K. companies with corporate directors makes it difficult to draw firm conclusions from the survey, it is interesting that so many of the surveyed firms were unable to offer a legitimate reason for using entities as directors. As disclosed below, perhaps they were unable to do so because corporate directors are often used for purposes at or over the edge of the law.^[25]

Nevertheless, there are legitimate reasons for companies to use corporate directors. In general, boards have three major functions. First, although day-to-day operational decision making is properly delegated to management, the board does have certain managerial functions. The Companies Act, for example, requires that the board of directors approve the terms on which the company will merge with another.^[26] More generally, the Corporate Governance Code provides that all companies should have “a formal schedule of matters specifically reserved” to the board.^[27] It further requires an annual report stating, inter alia, “which types of decisions are to be taken by the board and which are to be delegated to management.”^[28]

A major study of U.K. boards found some variance in how this aspect of the board’s role was operationalized, but concluded that “boards remain controllers of the strategic agenda.”^[29] The board serves as the “ultimate arbiter of what constitutes the focus of the company.”^[30] It sets the parameters within which management conducts the day-to-day operations.^[31]

Second, boards have a service function. Both individually and collectively, board members provide advice and guidance to top managers.^[32] This is an especially valuable and important role of the nonexecutive directors.^[33] A diverse board can expand the company’s network by providing interlocks with potential suppliers, customers, sources of finance, and other potential suppliers of key organizational needs.^[34] Research suggests that nonexecutive directors, in particular, play a valuable role in “‘opening doors’ for firms through use of contacts.”^[35] Finally, directors have an important institutional role in liaising with shareholders and other key company stakeholders.^[36]

Third, the board—especially its nonexecutive members—monitors the performance of management.^[37] Indeed, as is also the case in the United States, monitoring is the chief function of U.K. company directors.^[38] U.K. boards do so by setting the broad policies and strategic framework within which management conducts the firm’s business, reviewing and approving plans and budgets put forward by management, setting management compensation, and wielding the ultimate power to hire and fire managers.^[39]

All of these functions were cited by U.K. companies surveyed as advantages of corporate directors. To be sure, as noted above, 31 percent of the surveyed companies could not state any advantage provided by corporate directors, but 24 percent stated that corporate directors broadened the skill sets and knowledge possessed by the board.^[40] Nine percent of the surveyed respondents stated corporate directors provided greater continuity; 5 percent cited improved efficiency; and 2 percent cited access to a wider network, access to finance, and better decision making.^[41]

These claims are far from fatuous. To the contrary, a corporate director in fact has many potential advantages over individual natural persons.^[42] As to the board’s managerial function, a corporate director likely will make better decisions than a single individual.^[43] Most of what boards do involves exercising critical evaluative judgment, assessing proposals put forward by management, rather than original thinking.^[44] A considerable body of evidence demonstrates that groups are superior to individuals at making such judgments.^[45] Assuming most of the companies that serve as corporate directors themselves have multiple employees and directors, a corporate director brings to bear the combined knowledge and expertise of multiple individuals.^[46] Having multiple individuals serving collectively as a corporate director also increases the number of man hours devoted by each slot in the board.^[47]

In the exercise of its service role, the board’s function is to “enhance a firm’s ability to raise funds, to add to the reputation of the company through recognition of their name in the community, and to deal with threats in the external environment.”^[48] By interlocking multiple boards of directors, the board facilitates access to mission-critical resources by providing introductions, formal and informal communication channels, and helping coordinate ongoing relationships.^[49] A corporate director with multiple employees and directors, each of whom has their own network of clients and associates, should be far better at building a network of resources on which the firm can draw than individual directors.

Finally, as to the board’s monitoring function, a corporate director again has advantages over natural persons. In addition to the time and knowledge advantages already cited, which are of significant value in making informed assessments of management performance, corporate directors may often have better incentives than natural persons.^[50] At the very least, corporate directors should be no worse than natural persons whose incentives to effectively monitor management “are fairly limited since they capture so little of any gains and suffer so little of any losses from the decisions they make.”^[51]

In addition to these considerations, there are several practical ways in which corporate directors can be useful. For example, in Hong Kong, where corporate directors are also permitted,^[52] foreign investors outside Hong Kong use corporate directors—typically corporate service providers or financial institutions—as local nominee directors of Hong Kong companies so as to facilitate prompt handling of business matters such as signing documents.^[53] Where directors travel frequently, using a corporate director helps ensure that at least someone representing that director remains in town to deal with business matters as they arise.^[54] Finally, in the corporate group context, a parent corporation may appoint itself to the board of directors of a subsidiary to exercise direct control.^[55]

III. The Case Against Corporate Directors

The stated rationale for restricting the use of corporate directors was that they “bring about a lack of transparency and accountability with respect to the individuals influencing the company.”^[56] At a 2013 G7 summit, U.K. Prime Minister David Cameron called for global action against corruption, which he proposed accomplishing through “greater transparency, fair tax systems and freer trade.”^[57] In July 2013, the U.K. Department for Business, Innovation and Skills responded by promulgating a discussion paper advancing numerous proposals to increase the transparency of company ownership.^[58] The paper acknowledged that corporate directors can serve legitimate purposes, but objected that they could also be used “to conceal beneficial owners in a complex corporate structure and across multiple jurisdictions to facilitate illegal activity.”^[59] Accordingly, the paper requested comments on a proposal to prohibit corporate directors.^[60]

Concern about the use of corporate directors to conceal fraud and other misconduct is legitimate. Despite the low frequency at which U.K. companies use corporate directors, the Serious Fraud Office estimated that corporate directors figured in a quarter of the cases it investigated.^[61] A 2014 assessment of the need for reform concluded that:

Corporate directors—one company (or legal person) as the director of another—are inherently opaque with respect to the natural person in fact controlling a company. Where someone controls an appointed director—who might be acting irresponsibly as a “front” for them—there is also scope for opacity and a lack of accountability.
....
The use of irresponsible “front” directors who allow themselves to be controlled by another can similarly introduce opacity with respect to that control and lead to reduced effectiveness of corporate oversight.
Since all appointed directors have the same status under the law, there is no means of identifying how many appointed directors are acting irresponsibly as a front for another, nor how many people are seeking to control them. But we do know that international organisations and UK law enforcement consider such arrangements high risk in terms of facilitating crime such as money laundering.^[62]

Not surprisingly, the 2013 discussion paper elicited considerable support for a broad prohibition of corporate directors from law enforcement agencies, as well as numerous nongovernmental organizations (NGOs).^[63]

Nevertheless, the paper also elicited comments from business representative organizations arguing that a complete prohibition of corporate directors was unwarranted considering the potential benefits offered by corporate directors.^[64] At the same time, however, support for a change in the law increased if it were framed as a partial prohibition permitting exceptions for situations in which the risk of misuse is low.^[65] As we have seen, that is the approach the government eventually adopted.^[66]

IV. Assessing the Case Against Corporate Directors

Concerns about transparency and accountability could be addressed through disclosure and substantive regulation without sacrificing the benefits corporate directors provide. Indeed, much of the regulatory structure necessary is already in place.

A. Disclosure

As U.S. Supreme Court Justice Louis Brandeis famously observed, “Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”^[67] The U.K. has already taken steps to enhance corporate disclosures, which easily can be adapted to provide adequate information about the ownership structure of corporate directors.

In April 2016, the U.K. government implemented enhanced disclosure requirements with respect to most companies’ beneficial owners.^[68] All persons with significant control (PSCs)—defined as an individual who owns or controls more than 25 percent of the company’s stock or holds the right to appoint or remove a majority of the board of directors, among other criteria^[69]—who are known to the company must be placed on a PSC register that includes the PSC’s identity, date of birth, address, and other pertinent information.^[70] In addition, and more pertinent to present purposes, the PSC register must also include “relevant legal entities” (RLEs), which are defined, inter alia, as companies that are listed on an exchange or are required to maintain their own PSC register.^[71] The register need not contain information about the RLEs’ ownership structures because the RLEs typically will have to maintain their own registers or otherwise provide such disclosures.^[72] As with the ban on corporate directors, the new requirements were justified as necessary to improve corporate transparency and accountability.^[73]

Similar disclosure requirements could be imposed on corporate directors so that regulators and, if desired, the public, would know the identities of the corporate director’s own directors, officers, and major beneficial owners of its shares. To further promote accountability and transparency, such requirements could include a similar positive duty on the part of both the company appointing the corporate director and the company serving as the corporate director to ensure that all relevant information is fully disclosed.

To ensure full transparency, moreover, the full ownership structure of the corporate director should be part of the required disclosure. Unlike RLEs, some corporate directors may be small companies that are not required to maintain a PSC register or they may be foreign companies. Accordingly, the disclosure should include the ultimate beneficial owner of the corporate director as well as any intermediary corporations or other legal entities in the chain of ownership.

There are several analogous requirements in U.S. law. The SEC “requires disclosure of all twenty-five percent owners of direct owners” of a registered broker-dealer, “their twenty-five percent owners, and each successive twenty-five percent owner of a twenty-five percent owner, continuing up the chain of ownership until a reporting company is reached.”^[74] U.S. banking law likewise “mandates disclosure of extensive information about entities in the chain of ownership.”^[75] As these analogies suggest, it is possible to condition regulatory privileges—such as using a corporate director— on complete chain of ownership and control disclosure.

B. Liability Constraints

When a corporate director is involved in criminal or civil misconduct, the entity may be held liable. The more serious question is whether the ultimate beneficial owners of the corporate director can be held liable. Being able to reach those individuals and hold them liable will often be desirable from both a compensatory and deterrence perspective.

The principal means by which such individuals may be held responsible under U.K. law for the acts of a corporate director is the de facto director doctrine.^[76] “A person will be deemed to have acted in the capacity of a de facto director where that person performs management functions of a type and in a manner consistent with management functions ordinarily performed and associated with a formally appointed director (a de jure director).”^[77] In the leading case of Revenue and Customs Commissioners v. Holland, the U.K. Supreme Court identified several factors relevant to determining whether someone is a de facto director, such as

whether they were part of the company’s “governing structure”; whether they were “truly in a position to exercise the powers and discharge the functions of a director” of the company; whether they had “assumed the status and functions of a company director” or “assumed to act as a director of the company.”^[78]

The Hollands were a husband and wife who were shareholders and directors of a trading company called Paycheck Services.^[79] “Paycheck Services was the parent company of ‘Paycheck Directors,’” which served as a corporate director for a number of affiliated companies.^[80] Even though “Holland was the directing mind and will behind it all,” a majority of the court held that Holland was not a de facto director.^[81] The majority “placed a great deal of emphasis on the importance of the principle of separate legal personality” and worried that the de facto director doctrine could swallow that principle.^[82]

As illustrated by Holland, U.K. company law has a strong tradition of respecting the separate legal personalities of incorporated entities and their shareholders, directors, and officers.^[83] Indeed, while the U.K. recognizes a doctrine of piercing the corporate veil similar to that under U.S. law, U.K. courts are far less likely to do so than their American counterparts.^[84]

Strong policy reasons justify respecting the separate legal personality of an incorporated entity and its controlling person.^[85] Those reasons in fact are sufficiently compelling that I have elsewhere proposed that U.S. courts abolish the veil piercing doctrine.^[86] Limited liability encourages risk taking by allowing shareholders to insulate themselves from liability, for example, which encourages investment and resulting economic growth.^[87] While it is true that limited liability allows shareholders to externalize some of the costs of risk taking, the evidence shows that the introduction of limited liability spurred economic growth.^[88]

Conversely, as the Holland case illustrates, doctrines such as de facto directorships and veil piercing are difficult to apply. In Holland, “it is difficult to differentiate between those of his acts done as director of Paycheck and whatever other acts he carried out in the business wearing other hats.”^[89] The doctrinal tests courts use to make such distinctions, moreover, are inherently ambiguous. As Judge (later Justice) Benjamin Cardozo observed of the U.S. version of veil piercing, for example, it is “an enigmatic doctrine caught ‘in the mists of metaphor.’”^[90] Accordingly, as Judge Frank Easterbrook and Professor Daniel Fischel rightly argue, veil piercing “seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.”^[91]

Accordingly, I have argued that “the appropriate question is not whether the shareholder used the corporation as his or her alter ego, but whether the shareholder personally engaged in conduct for which he or she ought to be held directly liable.”^[92] Additionally,

[i]n many nominal piercing cases, the plaintiff in fact could have brought a direct action against the shareholder. In numerous cases, for example, the individual defendant said or did something that misled the creditor. In others, the individual defendant could be held liable either as a joint tortfeasor with the corporate defendant or on a vicarious liability theory. Because these examples capture the cases in which limited liability seems most problematic (i.e., those involving misrepresentation in connection with contract claims and deliberate externalization of unreasonable risks in tort cases), abolishing veil piercing would not leave deserving creditors without a remedy.^[93]

Interestingly, this approach to the problem would be consistent with the trend of U.K. law with respect to veil piercing. U.K. law increasingly focuses on whether the corporation’s controlling person has committed a wrong for which direct individual liability may be imposed.^[94] As a U.S. court applying U.K. law explained,

[W]here an individual (“B”) has, by making fraudulent misrepresentations, procured a contract between the plaintiff (“A”) and a third party (“C”), and C subsequently breaches that contract, any claim that A possesses against B sounds in tort rather than in contract, “even where C is the creature of B.” Thus, where “[t]he Claimants have their remedy ... in the form of an action for fraudulent misrepresentation,” “[t]here is simply no need ... to lift the veil at all.”^[95]

British courts and regulators should take the same approach to beneficial owners—and other controlling persons—of corporate directors. When the individual commits fraud or other serious violations, the fact that he did so while acting through a corporation should not bar imposition of direct personal liability. This approach would be directly responsive to the accountability concerns motivating the ban on corporate directors. It is generally accepted that one should not be held liable for harms one did not cause.^[96] Conversely, however, where the controlling persons of a corporate director are active participants in the harm-causing activity, they are properly held responsible.

Conclusion

Although the U.K.’s century-old tradition of allowing corporate directors raised legitimate transparency and accountability concerns, those concerns could have been addressed without the sweeping prohibition imposed by the SBEEA. Given the legitimate uses of corporate directors, as well as the potential for them to evolve into BSPs, the U.K. should consider replacing that prohibition with a regime allowing corporate directors but requiring extensive disclosures of the director’s ownership structure and imposing personal liability on the ultimate beneficial owner in appropriate cases. If that proves politically impractical, the relevant authorities should be willing to craft broad exemptions in situations where the risk of misconduct is modest.^[97]

* William D. Warren Distinguished Professor of Law, UCLA School of Law.