s172 Director's Duty – it's not just about the bottom line
The last year has seen a flurry of reforms in corporate governance with the introduction of the new Corporate Governance Code published by the Financial Reporting Council (FRC) in July 2018 (New UK Corporate Governance Code), the Wates Principles to improve corporate governance standards among private companies published in December 2018 and the introduction of the new corporate governance reporting requirements in the Companies (Miscellaneous Reporting) Regulations 2018. These corporate governance reforms resulted in additional reporting obligations covering a wider range of companies for accounting periods beginning 1 January 2019. The first reporting obligations will therefore come into effect next year, and will apply to many companies who would not previously have had to prepare these reports – broadly speaking being companies which have any 2 of turnover exceeding £36m, balance sheet assets exceeding £18m and greater than 250 employees.
In the meantime, boards of affected companies are busy preparing and piecing together the puzzle of these reporting requirements.
One of the key themes of these governance reforms is the introduction of an annual reporting requirement in relation to section 172 of the Companies Act 2006, commonly known as the s172 Director's Duty. This is the well-known duty to "promote the success of the company for the benefit of its members as a whole", whilst have having regard to various other stakeholder interests.
The purpose of the s172 Director's Duty is to encourage boards of companies to create a culture whereby decisions are made with greater consideration for the wider impact upon the organisation beyond the traditional emphasis on just financial performance and strategic objectives. As we will explore in this article, the good news is that compliance with the new regulatory requirements – whilst an additional burden for some companies – can lead to a raft of hidden benefits being unlocked.
What is the s172 Director's Duty and what do company directors need to consider when making decisions?
Section 172(1) of the Companies Act 2006 provides that a director of a company must act in a way that 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 various other stakeholder interests – below are the six key factors:
- the likely consequences of any decision in the long term;
- the interests of the company's employees;
- the need to foster the company's business relationships with suppliers, customers and others;
- the impact of the company's operations on the community and the environment;
- the desirability of the company maintaining a reputation for high standards of business conduct; and
- the need to act fairly between members of the company.
The duty of the directors under s172 is to act in good faith and to exercise their powers diligently. This duty is owed to the company and not directly to its shareholders or other stakeholders. However, the law recognises that the factors listed above need to be part of the assessment when directors make decisions. The directors, in carrying out their role, must use their own skill and judgment and have regard to the likely long-term consequences of their decisions, in order to prioritise the long term success of the company. How the directors address the interests of shareholders and stakeholders is a matter for them, but they should make this assessment in good faith.
Section 172(2) is less well known, but is also of importance and is linked to a company's purpose – where the company's purposes consist of or include purposes other than for the benefit of its members, the director must act in the way they consider, in good faith, would be most likely to achieve those purposes. Companies are therefore free to adopt other purposes in their constitutions.
When does the s172 Director's Duty change?
It should be noted that in s172(3), the duty is subject to any enactment or rule of law requiring directors in certain circumstances to consider or act in the interests of the creditors of the company. Accordingly, the duty is modified when the company is insolvent, on doubtful solvency or on the verge of insolvency.
In these situations, the directors have to consider the interests of the company's creditors as paramount, and take those interests into account when carrying out their duties to the company.
The vital link between the s172 Director's Duty and a company's culture
Guidance produced by GC100 (The Association of General Counsel and Company Secretaries Working in FTSE 100 Companies) focuses on how directors can have regard to the s172 factors in everything that they do as directors.
The guidance sets out five areas of focus to help directors embed s172 in decision making in the company, all of which are tied together by one over-arching theme, the company's "culture" (which is also a key theme from the New UK Corporate Governance Code). The five areas are:
- strategy - the need for the company to reflect the directors' s172 duty when establishing and updating its strategies;
- training – providing training to its board members on their s172 duty;
- information – providing directors with the information they need to enable them to carry out their role, mindful of their s172 duty;
- policies and procedures – putting appropriate polices in place to support the company's strategy and goals in the light of s172; and
- engagement – considering how best to engage with employees and other stakeholders.
The impact of s172 on a company's culture is therefore clear. By following these areas of focus company directors will both comply with their legal obligations but also help create a culture of benefit for shareholders, employees, customers and other stakeholders.
It is therefore quite apt to remember Sir Win Bischoff's (Chairman of the FRC), comments published in the ICSA Governance + Compliance article over two years ago about culture in the business:
"Culture is a combination of values and attitudes, and the behaviour they drive, the purpose of the company, and the way that stakeholders are treated – staff, customers, society and so on. It is a broad area which impacts the behaviour of the company and the way it is seen in the outside world."
The board as a whole is responsible for setting the culture of a company. The board must assess, gauge and be able to ascertain that the right culture is embedded and encouraged throughout the company, and that executives and management play an active part in making this happen.
The combination of all the new governance reforms points to the direction of encouraging positive change of culture in companies or the strengthening of embedded culture in companies which are already doing well.
Engagement and the purposeful business: how compliance with the s172 Director's Duty can help companies flourish
The British Academy launched a programme of research and dialogue called The Future of the Corporation led by Professor Colin Mayer, who has commented (as published in ICSA Governance + Compliance 'Company law allows a purpose beyond profit') that under the Companies Act 2006 "it is perfectly feasible for companies to focus on purpose" and that "they are being increasingly encouraged to do so". The relevance of s172(2) and building purpose into the constitution of a company is evidence of a company's commitment. Professor Mayer further commented that "companies should incorporate around purpose and purpose should be part of their articles".
The emphasis on a company's culture is reflected in the concept of the 'purposeful business' , which is becoming increasingly relevant today, with shareholders and investors become more demanding of, and showing an increased interest in, the ethics of the companies in which they are investing.
The Purposeful Company Report published by the Big Innovation Centre in 2017 found that a guiding collective purpose in an organisation leads to improved performance and higher profit. An added benefit is the increase in employee satisfaction, as well as enhanced customer loyalty.
Attracting and retaining talent is a core priority for successful companies, and engaging with employees plays a vital part in this. Acas included in its list of the top 4 ingredients to a happier, more motivated and more productive workforce the opportunity for employees to be able to voice their views and concerns.
A Harvard Business Review Analytics survey concluded that "companies able to harness the power of purpose to drive performance and profitability enjoy a distinct competitive advantage". Michael Beer reported that there is "an increasing awareness that the purpose of a company has to be beyond shareholder value", and that this "will enhance your business".
Purpose can have a dramatic effect on staff retention. According to Deloitte's 2016 Survey of Millennials, 88% of millennials are likely to stay at a purpose driven company for five years if they are satisfied with the company's mission.
On consumers' feedback, it was reported that almost three-quarters of the public say that they are more likely to buy from or engage with businesses that have an objective beyond merely generating profit.
Conclusion: compliance, culture and success are inextricably linked
The board of directors is the key decision-making body in a company. It therefore follows that a company must have an effective board of directors who are dedicated to ensuring that the company maintains its culture and achieves its purpose. Collectively, the directors must provide entrepreneurial leadership and direction to the company. The "success" of a company is not defined in the Companies Act 2006, but the term is likely to be interpreted as meaning "increasing value for shareholders". The s172 duty specifically mentions that directors must have regard to the company's employees, customers, suppliers and the community in particular.
It therefore appears that the promotion of the success of the company is a form of "enlightened shareholder" approach to corporate governance. A board that can demonstrate that it has suitable governance procedures or policies (such as policies in relation to environmental issues, sustainability, recruitment, pay, diversity, payment policies, risks or internal controls) would likely generate trust and support from its shareholders and other stakeholders.
Now is the time for directors to fully engage with their workforce and wider stakeholders, in the knowledge that an enlightened approach to corporate governance will not only help the directors comply with their legal obligations under s172, but also assist in the wider success of the company.
For guidance on directors' duties and other governance issues, including Michelmores' Company Secretarial and Corporate Governance services, please contact Caroline Lavis.