Companys Relationship with Stakeholders - Essay Example

The approach to disclosure in the Companies Act 2006 is preoccupied with one audience, shareholders. Until a robust stakeholder approach is developeddisclosure will continue to be an expensive but ineffective form of regulation. Introduction Corporate governance has evolved beyond merely focusing on the contractual relationship between management and shareholders and now takes into account the company’s relationship with stakeholders. The underlying rationale is that companies are more responsible when stakeholders are in a position to respond to the activities of the company, which in turn has some influence on the activities and decisions of the company.1 Stakeholder and legitimacy theories advance the argument that companies are required to demonstrate that they are legitimate operations and this legitimacy must be demonstrated not only to shareholder but to a wider class of stakeholders.2 The obvious way for companies to prove legitimacy to the wider class of stakeholders is through reporting requirements. Unfortunately, the Companies Act 2006, while recognizing the social contract between the company and stakeholders, does not make social and environmental reporting mandatory. A close reading of the relevant sections of the 2006 Act reveals that environmental and social reporting are entirely voluntary.3 It is therefore reasonable to conclude that the Companies Act 2006 has shifted momentum in favour of stakeholder theory to the principle of shareholder primacy.4 Clark and Knight argue that the disclosure requirements contained in the Companies Act 2006 appear to meet the needs of shareholder and while they may appear to meet the needs of stakeholders, the disclosure requirements are motivated by the market value of the corporation rather than expanding the concept of corporate social responsibility.5 In this regard, the disclosure requirements of the Companies Act 2006 speaks to informing the shareholders of the company rather than to all stakeholders. Essentially, companies, may if they wish, inform stakeholders of their social and environmental activities and policies, while they must inform shareholders of their financial activities and policies. This is symptomatic of the ambiguous approach taken by the Companies Act 2006 to stakeholder and shareholder primacy. While there appears to be a convergence of both shareholder and stakeholder primacy models, the reality is, shareholder primacy continues to override stakeholder primacy.6 Therefore, in the absence of a robust stakeholder approach, disclosure will continue to be an ineffective and expensive form of regulation. This paper illustrates the shareholder primacy implicit in the disclosure requirements of the Companies Act 2006 and examines how this approach perpetuates the view that stakeholder primacy while evolving, continues to remain overshadowed by shareholder primacy. Disclosure Requirements under the Companies Act 2006 Any understanding of the disclosure requirements contained in the Companies Act 2006 must be prefaced by the objectives of the 2006 Act. Talbot informs that the objectives of the Companies Act 2006 is to confirm that the company is operated for shareholders and that stakeholder interests should be met in terms of “modern business practices”.7 While seemingly neglectful of stakeholder primacy, this is an important milestone for the development of corporate culture and law in the UK. Under UK company law, the tradition has always been that the directors owe to their company as whole, a duty of loyalty.8 It has also been widely accepted that the term company as a whole, means all shareholders, current and future.9 With the Companies Act 2006 reportedly aimed at ensuring that the company directors operate the company for shareholders and meet stakeholder interest pursuant to modern business practices, although imprecise and tenuous, demonstrates at the very least, that shareholders are not the only focus of directors’ duties. Even so, the Companies Act 2006, falls short of providing a definitive role for stakeholder interests. It is therefore hardly surprising that directors are not statutorily bound to disclose information relevant to stakeholder interest, although they may voluntarily include information corresponding with stakeholder interests in their annual disclosure requirements. Voluntary reporting however, while insufficient to meet the needs of stakeholders remains an improvement on the previous corporate culture geared toward merely meeting the needs of shareholders. This is more prominently reflected in the disclosure requirements prior to the implementation of the Companies Act 2006. Previously, the Companies Act 1985 as amended required that directors file a report annually. The report was only required to include: an objective report of the company’s business; and the primary risks for the company.10 Quoted companies were responsible for reporting an Operating and Financial Review together with the opinion of an auditor reflecting the congruency of the Operating and Financial Review with the company’s accounts.11 Note, that companies had no obligation to consider reporting social and environmentally sensitive information. The obvious implication was that the company only needed to meet the needs of its shareholders and that social contracts were of no significance to the company’s operations. The Companies Act 2006 goes into more details relative to disclosure duties and at least recognizes that stakeholder interests has some significance. Like the Companies Act 1985, directors are also required to file a directors’ report which must include a business review.12 If the company is characterized as a small company, the director need only report a business review.13 Section 417 (2) is instructive in that it specifically directs attention to the interests of shareholders. Section 417 (2) provides that if a company is not entitled to a “small company exemption”, the director’s report must include a business review. Section 417(2) goes further to state that: The purpose of the business review is to inform members of the company and help them assess how the directors have performed their duty under section 172 (duty to promote the success of the company).14 Thus Section 417(2) raises a number of issues requiring further scrutiny. To begin with the Business Review is required to include all the same information contained in the Companies Act 1985. By implication the main audience is the company’s shareholders. However, reference to Section 172, specifically calls attention to the concept of corporate responsibility and thus the interests of the stakeholder.15 Specifically Section 172 of the Companies Act 2006 provides that the general duty of the director is to promote the success of the company. In doing so, the director is required to not only take business outcomes into considerations relative to business decisions, but also wider social consequences inclusive of the environment, the company’s impact on the community and the interests of employees.16 Talbot’s contention that the purpose of the Companies Act 2006 is to safeguard the interests of shareholders in the context of modern business practices immediately takes on more relevance. Elkington’s observation sheds more light on Talbot’s comments. Elkington argues that businesses operating in the 21st century should have three primary targets: the maximization of shareholder profits; social and environmental objectives that can be audited.17 In other words, shareholders can only be one primary focus of the modern business practice. Modern businesses must also take account of observable social and environmental actions. The infusion of Section 172 into Section 417 (2) of the Companies Act 2006 specifically calls attention to social and environmental issues which invariably means that stakeholders are essentially part of the reporting or disclosure duties of companies. The Organization for Economic Cooperation and Development developed guidelines as far back as 1976 for multinational companies that reflect this principle. The Guidelines incorporate best practices for multinational companies that include taking account of wider social and environmental issues and human rights.18 It is therefore patently obvious that modern business practices are intended to take account of social and environmental issues. In fact, the UK government’s Department for Environment Food and Rural Affairs (DEFRA) notes that a company that takes account of, regulates and communicates its environmental conduct are companies in good standing. These companies not only know how to enhance their operations, minimize costs and adhere to the requirements for regulating their business operations, but they also know what the expectations of their stakeholders are. The Department goes further to state that: Failure to plan for a future in which environmental factors are likely to be increasingly significant may risk the long-term future of a business. Good environmental performance makes good business sense. Environmental risks and uncertainties impact to some extent on all companies, and affect investment decisions, consumer behaviour and Government policy.19 Therefore, if the purpose of the business review is to ensure that the company’s members know that the directors are performing their duties pursuant to Section 172, the shareholders are not the only target of the disclosure requirement under Section 417 of the Companies Act 2006. Promoting the success of the company informs that stakeholder interests are significant. Jensen explains why stakeholder interest cannot be separated from shareholder interests under his enlightened shareholder theory or maximization of value theory. Jensen argues that: The intuition behind this criterion is simply that (social) value is created when a firm produces an output or set of outputs that are valued by its customers at more than the value of the inputs it consumes (as valued by their suppliers) in such production. Firm value is simply the long-term market value of this stream of benefits.20 Drawing on Jensen’s enlightened shareholder theory or the maximization of value, the director cannot promote the company’s success by merely focusing on shareholder maximization. The company is not likely to be successful if its operation simply ignore the environment and the impact of its business practices on the wider community. Customers are not likely to value the company and its goods or services in the long term if a company indiscriminately focuses on profits. When customers refuse to value the companies and its goods and services, it is only a matter of time before the company’s success is turned upside down. Therefore the disclosure requirements which specifically call attention to the director’s duty to report for the specific purpose of informing members of the company that they are promoting the company’s success, that disclosure must necessarily reflect how the company is functioning within the environment and the community. Section 417(5) is more specific with respect to quoted companies. Section 417(5) of the Companies Act 2006 provides that the business review is required “to the extent necessary for an understanding of the development, performance or position of the company’s business,” provide: Information about the environmental matters (including the impact of the company’s business on the environment), the company’s employees, and social and community issues, including information about any policies of the company in relation to those matters and the effectiveness of those policies…21 Arguably, since Section 417(5) goes into specific detail about stakeholder obligations in the reporting requirements for quoted companies, other companies that are not exempt as small companies under Section 417 (2) do not share an identical requirement. Section 417(3) only states that the business review must include “a fair review of the company’s business” and a “description of the principle risks and uncertainties facing the company”.22 Further details are found in Section 417(4) which provides that: The review required is a balanced and comprehensive analysis of the development and performance of the company’s business during the financial year, and the position of the company’s business at the end of that year.23 All indications are therefore that companies that are not quoted companies and are not exempt as a small company do not have a duty to disclose anything other than the company’s financial activities as implied by the requirement to file this information for the financial year. However, since Section 417(2) states that the purpose of the business review is to inform the members of the company that the directors are promoting the company’s success suggest otherwise. A closer examination of Section 172 is therefore required. In order to promote the company’s success the director must necessarily take into consideration a variety of factors inclusive of the results “any decision in the long term”; the interests of its employees’; the interest of the company’s business associates and consumers; the community and the environment; the reputation of the company and “and the need to act fairly as between members of the company”.24 Jensen’s maximization of value informs that the company’s success depends on long term goals and objectives which must take account of the company’s impact on the community, the environment and consumers and not just the profit returns for shareholders. Focusing strictly on shareholder maximization would only have short-term value.25 It is therefore unclear whether or not Section 417 (2) intends to ignore stakeholder values and to merely ensure that the business review satisfies the curiosity of shareholders. However, it would appear that any doubts about the extent of disclosure obligations with respect to companies that are not small or quoted, are resolved by Section 417(6)(b) of the Companies Act 2006. Section 417(6) provides that the business review, “must to the extent necessary for an understanding of the development, performance or position of the company’s business” provide an evaluation utilizing indicators demonstrative of performance, and: Where appropriate, analysis using other key performance indicators, including information relating to environmental matters and employee matters.26 The phrase “where appropriate” as it appears in Section 417(6) suggests that Section 417(2) does not require reports to include environmental and employee matters. However, it can also be argued that Section 417(6) may be a reminder that small companies are exempt from the detailed reporting requirements. Similarly, Section 417 (5) appears to provide that the reporting requirements relative to quoted companies in respect of environmental and employee matters are not mandatory. Section 417(5) provides that in the event the business review does not include information relative to the environment, employees and social and community matters, the report must “state which of those kinds of information it does not contain.”27 Therefore the phrase “where appropriate” may simply be referring to cases where the quoted company fails to include environment, employee and social and community information. Regardless, the mere fact that the disclosure of this information is not mandatory speaks to the shareholder primacy of the disclosure requirements pursuant to the Companies Act 2006. More importantly, it is demonstrative of the tenuous nature of stakeholder primacy in corporate culture. The relative insignificance of shareholder primacy is again reflected in Section 417(7) of the Companies Act 2006. Section 417(7) provides that mid-sized companies are not required to comply with the “non-financial” reporting requirements under Section 417(6).28 Therefore, medium-sized companies are not even required to consider filing information that stakeholders might benefit from. In other words consumers are at risk of purchasing in ignorance of environmental damages that are not observable in the short term. Similarly, communities may support or tolerate a company’s presence in the community, despite the fact that it might be damaging the community, although the impact is not immediately obvious. More importantly, the lack of stakeholder scrutiny also implies that the social contract is secondary to the shareholder contract. There is an erroneous perception that corporate legitimacy is tested by shareholder scrutiny, a flawed concept evidenced by corporate governance failures in the past. Section 417(9) goes further to reflect a distancing from stakeholder approaches to corporate transparency. Section 417(9) ensures that the community, employees and consumers are deprived of an opportunity to object to a potentially damaging company project. Section 417(9) specifically provides that: Nothing in this section requires the discloser of information about impending developments or matters in the course of negotiation if the disclosure would, in the opinion of the directors, be seriously prejudicial to the interests of the company.29 Section 417(9) of the Companies Act 2006 is difficult to reconcile with Section 417(2) which directs attention to the duty to promote the success of the company as contained in Section 172. If a disclosure of a pending development is against the company’s interest, it is difficult to imagine how the actual development would not be against the company’s interest. Therefore, the pending development must therefore be a project that would not promote the success of the company. The uneven disclosure duties under the Companies Act 2006 is further exemplified by the fact that there are no remedies against directors for failure to comply with Section 417. However under Section 418 which relates to the directors’ duties to facilitate an audit and an audit statement in the directors’ report provides for criminal sanctions in the event the director facilitates a false audit statement.30 The audit statement is obviously meant to appease shareholders and to protect their interests in the company as it relates to the manner in which the directors are conducting the financial aspects of the company. The fact that there are criminal sanctions indicates that the duty to make full and frank disclosure for the benefit of the shareholders is not only mandatory but very seriously enforced. Conclusion There is little doubt that shareholder primacy occupies a high priority in UK corporate culture, law and practice. The inescapable conclusion is that, the company’s purpose is to preserve and enhance the investment of its shareholders.31 The debate over the enhanced interest of stakeholders and the degree to which this might influence the companies’ activities has gained some currency in the UK as evidenced by Section 172 of the Companies Act 2006. However, the disclosure requirements in the 2006 Act trivialize any advances toward accepting that stakeholders have an interest in companies’ operations. This trivialization must be viewed as no more than a reflection of the absence of a robust stakeholder approach to corporate functioning and regulation under UK law. Disclosure for the benefit of stakeholders is at its highest, merely voluntary. This is indicative of the tenuous position of stakeholder primacy in UK company law. Stakeholders are a class of interested persons that corporate management may take account of, only if it advances shareholder interests. Otherwise, there is no reason to assume that stakeholders are of any relevance to corporate governance and disclosure requirements simply correspond with this principle. Bibliography Articles/Journals Armour, J.; Deakin, S. and Konzelmann, S. ‘Shareholder Primacy and the Trajectory of UK Corporate Governance.” (June 2003) ESRC Centre for Business Research, University of Cambridge, Working Paper No. 266, 1-31. Clark, G.L. and Knight, E.R. W. ‘Implications of the UK Companies Act 2006 For Institutional Investors and the Market for Corporate Social Responsibility.’ (2009)11(1) U. of Pennsylvania Journal of Business Law, 259-296. Jensen, M.C. ‘Value Maximisation, Stakeholder Theory, and the Corporate Objective Function’. (2001)7(3) European Financial Management, 297-317. Reisberg, A. and Haversroft, I. ‘Directors’ Duties Under Companies Act 2006 and the Impact of the Company’s Operations on the Environment,’ (Dec. 2010) UCL Faculty of Laws: Centre for Commercial Law, 1-40. Textbooks Bartman, S. European Company Law in Accelerated Progress. (Kluwer Law International 2007). Davies, P. Gower and Davies’ Principles of Modern Company Law. (7th Edn, Sweet and Maxwell, 2003). Elkington, J. Cannibals with Forks: The Triple Bottom Line of the 21st Business. (New Society Publishers, 1998). Faure, M. Globalization and Private Law. (Edward Elgar Publishing 2009). Horrigan, B. Corporate Social Responsibility in the 21st Century. (Edward Elgar Publishing 2009). Solomon, J. Corporate Governance and Accountability. (John Wiley and Sons, 2007). Talbot, L. Critical Company Law. (Oxford: Routledge Cavendish, 2008). Table of Statutes Companies Act 1985 (as Amended). Companies Act 2006. OECD Guidelines for Multinational Enterprises 1976. Table of Cases Multinational Gas and Pretrochemical Co. v Multinational Gas and Petrochemical Services ltd. [1983] Ch 258. Internet Resources UK Department for Environment Food and Rural Affairs, ‘Environmental Responsibilities’, (n.d.) http://www.businesslink.gov.uk/bdotg/action/layer?r.l1=1079068363&r.l2=1086048458&r.s=tl&topicId=1079433025 (Retrieved 29 April 2011). Read More