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Company law allows a purpose beyond profit

14 May 2018 by Tom Fox and Luke Fletcher

Company law allows a purpose beyond profit - Read more

Legal requirements offer opportunities for business to be driven by more than shareholder value

From academia to boardrooms, the notion of purposeful business is attracting increasing attention.

Larry Fink, founder and CEO of BlackRock, recently made headlines by making ‘a sense of purpose’ the theme of his 2018 letter to CEOs, writing: ‘Without a sense of purpose, no company, either public or private, can achieve its full potential.’

When the world’s largest asset manager tells companies that society demands that they serve a social purpose, they sit up and take notice.

The same message has been coming from academics and practitioners for some years. Reviewing existing evidence on the subject, the Big Innovation Centre’s ‘Purposeful Company’ report found that a strong sense of collective purpose can enhance a firm’s commercial performance, driving employee satisfaction, customer loyalty and long-term shareholder value.

Alongside this, for large companies a key driver is attracting and retaining talent. Harvard Business School Professor Michael Beer is among academics reporting ‘an increasing awareness that the purpose of a company has to be beyond shareholder value’, noting that this ‘will enhance your business’.

“When the world’s largest asset manager tells companies that society demands that they serve a social purpose they notice”

At the same time, an increasing number of start-ups are being set up with a purpose beyond profit at their core. Many of the business leaders of tomorrow instinctively want to combine doing well with doing good.

They have customers on their side: 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.

Opportunity in law

It appears that we are now reaching a tipping point, when this burgeoning interest in purposeful business is translating into practical questions about company law and governance. How does a company’s purpose affect the duties of directors? What does it mean for the relative priority given to the interests of shareholders versus other stakeholders?

Section 172(1) of the Companies Act 2006 is relatively well known, defining a director’s duty ‘to promote the success of the company for the benefit of its members as a whole’, while having ‘regard to’ various other stakeholder interests. Section 172(2) is less well known, but is of profound importance: it allows a company to identify another purpose, alongside or instead of this default.

Professor Colin Mayer, who leads an ambitious programme of research and dialogue for the British Academy called the Future of the Corporation, is emphatic on this point: ‘[Under] the Companies Act, it is perfectly feasible for companies to focus on purpose.

Indeed, they are being increasingly encouraged to do so.’ But he also points out that companies ‘need the tools to conceptualise and implement their purpose.’

Making purpose tangible

For all the current interest in purposeful business, relatively few companies are taking substantial steps to embed their purpose. Critics argue that claims about purpose are superficial and unsubstantiated – more PR than DNA. The term ‘purpose-wash’ has already been coined.

Accordingly, public opinion is sceptical. Representative polling commissioned by UnLtd in January 2018 found that 40% of respondents thought purpose was more likely to be used for marketing and corporate spin than for strategy and important decisions. 61% thought that claims about business purpose are often not backed up with any substance.

When asked what steps would convince them that a business is taking its purpose seriously, the most popular answers were ‘publishing a report’ about how purpose is implemented in practice and ‘making purpose legally binding’, at 55% and 54% respectively.

Having a board member responsible for purpose came third at 37%. As a whole, these governance-related measures were viewed as significantly more convincing than product-related or marketing-related options.

Building purpose into the constitution and governance of the business is becoming seen as the real litmus test of a company’s commitment. Professor Mayer is clear on this: ‘Companies should incorporate around purpose and purpose should be part of their articles of association.

“Building purpose into the constitution and governance of the business is becoming seen as a real litmus test”

Companies should then demonstrate that everything that is associated with those businesses – their ownership, their governance, their leadership, the things that they measure in terms of their performance, their incentives – all of these are aligned to the delivery of their purpose.’

Directors may ask whether embedding a purpose into the company’s articles creates new liabilities. Embedding purpose in the articles redefines what success means for the business and therefore reshapes directors’ duties, so that directors are obliged to make decisions in line with the purpose.

As with any business, the company may have a claim against directors who breach their duties. However, it does not create any new rights for the company or for third parties and so does not create new forms of liability for directors.

Indeed, embedding a purpose in the articles clarifies the duties and mandate of directors by more closely defining business success, thereby reducing the risk and consequent uncertainty of the articles contradicting purpose-related statements or policies held elsewhere.

Understand your options

The legal flexibility to incorporate around a purpose is neither well understood nor readily accessible for mainstream companies.

Although charitable companies and community interest companies are required to define their purposes and community benefit respectively, founders of conventional limited companies are not prompted or invited to consider or specify their purposes. For example, anyone using the Companies House web incorporation service may only use the default model articles.

The ‘Mission-Led Business Review’, published in December 2016, recommended that government should raise awareness of the legal flexibility to embed purpose and establish clear ways for companies to take advantage of it.

In response, the government has backed the development of a new digital tool, Purposely, that helps founders to embed their purpose in their constitution. This was developed by UnLtd and Bates Wells Braithwaite, with input from Companies House and other stakeholders.

Behind Purposely are four amended versions of the model articles for a company limited by shares, corresponding to different types of purposeful company. Common to all are the ability to specify a particular purpose; a commitment to report in relation to the purpose; and a commitment to a set of self-defined responsible business principles.

Each version specifies a different treatment of the relative interests of shareholders and other stakeholders, and certain other commitments. By answering a series of questions about their businesses, users are told which of the versions is likely to best fit their needs.

  • Model 1: This is the closest version to the model articles, retaining the default treatment of members’ interests in comparison with those of other stakeholders.
  • Model 2: The company pursues an overall positive impact on society, and can specify a more specific purpose if desired. Members’ interests are treated on a par with those of other stakeholders.
  • Model 3: The company has a primary social purpose and prioritises this above the interests
    of members.
  • Model 4: As with Model 3, the company has a primary social purpose. It makes commitments on the treatment of profits and use of assets, in effect meeting the definition of a social enterprise.

Purposely was designed with new company founders in mind, but it will also be useful for advisors and intermediaries whose clients are interested in embedding purpose and more established, larger companies that would like to understand what is possible.

Looking forward

Current policy shifts are pointing to a future in which companies are required to be more cognisant of and transparent about their purpose. The Financial Reporting Council recently proposed changes to the UK Corporate Governance Code, putting purpose centre stage.

The proposed revised text states that a board ‘should establish the company’s purpose, strategy and values, and satisfy itself that these and their culture are aligned.’ The proposed revised guidance on board effectiveness recommends that ‘boards should start by determining the company’s purpose and clearly defining a set of values that are aligned to that purpose and the company’s strategy.

Simply adopting a formal values statement is not enough. In order to have an impact on behavioural outcomes and influence the way business is done, values need to be embedded at every level of the organisation.’

“Building purpose more systematically into companies could be key to the business community rebuilding public trust”

Although there is ongoing debate about the detail of these proposed revisions, the trajectory is clear, underpinned by widespread concern about the loss of trust in business in recent years.

While holding the small business and corporate responsibility brief, previous business minister Margot James MP spoke of ‘the opportunity to encourage more businesses to use the flexibility in company law to embed corporate purposes beyond the benefit of members.’ The FRC’s proposals show that purposeful business is not just about mission-driven start-ups.

Building purpose more systematically into the constitution and governance of companies, large and small, could be key to the wider business community rebuilding public trust, and delivering the productive and inclusive economy that Theresa May and her government have set their sights on.

Although humble and often ignored, s172(2) of the Companies Act is of profound significance, and likely to attract increasing attention from governance professionals during the coming years.

Tom Fox is former head of policy and strategic partnerships at UnLtd; and Luke Fletcher is a partner at Bates Wells Braithwaite llp. For more information about Purposely, visit getpurpose.ly

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