In-house solicitors will be familiar with the obligations of directors as set out in section 172 of the Companies Act 2006 (especially now there is a statutory requirement to report on it). Many of those same solicitors will be equally familiar with directors (newly appointed or otherwise) who believe that they have a legal obligation to maximise profit for the shareholders, and that this constitutes an ‘overriding duty’ or a director’s main ‘fiduciary duty’.
This fallacy persists for a number of reasons, including:
• Pressure from heavyweight shareholders who benefit most from short-termist decision making.
• Bonus and other reward packages.
• An easy metric that everyone understands.
• Fear of competitors.
However, the legal obligation in section 172 of the Companies Act 2006 is far more nuanced and provides a clear set of criteria which many directors may be surprised by. Now is an excellent time to revisit the fallacy of a legal obligation to maximise profit. We are in an age where environmental and social governance issues are rocketing up the corporate agenda and climate crisis is threatening both short and long-term stability. Section 172 speaks directly to those concerns.
Section 172 sets out a legal duty to ‘promote the success of the company for the benefit of its members as a whole’. Members are those parties whose names are on the register of interests. For companies limited by shares, this includes shareholders. This sets up the first conflict; different shareholders will be more or less benefited by short, medium or long-term strategies. Promoting success for the benefit of the members as a whole means balancing the interests of different shareholders. It is important to periodically check that the business strategy is not unduly or arbitrarily favouring one set of shareholders (usually the short-term investors). But the section 172 duty goes further than simply balancing the benefit between different types of member.
The duty must be also be discharged with regard to the following additional factors:
• The likely consequences of any decision in the long-term.
• The interest 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.
This means that a director must consider all the above factors and then decide the course of action which will lead to the ‘success of the company for the benefit of the members as a whole’.
It is often the case that actions to maximise profit e.g. paying staff below the living wage, making redundancies, or pursuing operations which damage the environment, not only fail to align with the above factors but do not preserve long-term success. Even if, in the shorter term, they have a positive impact on the company’s bottom line.
It is also the case that you could have two options, both of which lead to long term success for the company:
• Option One: a slightly more profitable option which ignores the impact of the above factors.
• Option Two: a slightly less profitable one which preserves them.
There is nothing in the legislation which states that you must pick Option One. Both meet the criteria for success and one of them meets the other factors as well.
It is not easy to find examples of Option Two decision-making, since most decisions of this nature are taken behind the closed door of the board room. However, some recent events have shown companies who are willing to take a lead and weigh up these complex and competing factors.
On the 20th September 2019 there was a worldwide climate strike. Whilst many companies were reviewing their HR policies and deciding whether or not to grant staff leave on the 20th September, others took a different approach. The Body Shop stated that staff could use one of their allocated volunteering days to attend the strike. Lush Cosmetics and Patagonia not only encouraged staff to attend but shut down offices and stores in support of the strikes.
In another, earlier, example L’Oreal ceased animal testing on their products 14 years before regulations required and the technology they developed on this journey, is now a source of revenue. Sacrificing a modest amount of short-term profit can be hugely beneficial in the longer term.
What does this mean for your business?
- Check your directors’ understanding of their Section 172 duty and ensure you have a training programme for new directors that encompasses it.
- Review your business strategy to ensure it is compliant with section 172 and takes into consideration all relevant factors.
- Review your policies and processes to ensure that section 172 is embedded into the decision making of the company.
- Check that section 172 factors are embedded in the training given to decision makers at all levels of the business e.g. are third party suppliers chosen with the section 172 factors in mind?
- Check your information flows are both relevant and sufficient to support section 172 decision-making.
For more in-depth guidance on embedding section 172 (and how it intersects with other duties in sections 173, 174 and others) in your business you might like to look at the GC 100’s paper from October 2018 here.
Ultimately the fallacy of the duty to maximise profit is deeply embedded in the wider business culture and resisting it in favour of the broader and more balanced legal requirement will require active work on the part of the board.