Big Red Car here. Bit wet in the ATX this morning. Nice little storm with a bit of Mother Nature’s lightning this morning. Even the rain in the ATX is good.
So further to the discussion of CEO and Board duties, the Big Red Car overheard the following.
The duties of a Board to the shareholders of a company — public or private — are very high. Being a Board member is therefore a very serious undertaking and not one to be embraced lightly.
Who does the Board represent?
The Board represents all the shareholders of the corporation. [For sake of this discussion, we are focusing on business boards rather than non-profit or, perhaps, educational institution boards. Big Red Car bit serious on this rainy morning, no? Finally, Big Red Car.]
The shareholders are the owners of the corporation.
Board members do not represent THEIR shares, they represent all of the shareholders — individual shareholders, minority shareholders, large shareholders, majority shareholders. All shareholders equally.
This fact often sets off an alarm as to conflicts of interest in that what might be good or prudent for a large shareholder might not be equally prudent for a small shareholder. The resolution of this fundamental conflict is perhaps the most important consideration that Board members may face on a routine basis. It is real.
Directors — Board members — are often those who have great interest in the corporation and by that measure are often large shareholders in addition.
This is NOT necessarily a bad thing and may, in fact, be a very good thing. Who’s going to look after an enterprise better than someone who owns a big stake in its future and outcomes?
The nature of a Board member
Board members are described as “inside” or “management” Directors when they are employees of the corporation.
Board members are described as “outside” or “independent” Directors when they are not direct employees of the corporation.
The notion of independent Directors is a very important distinction as certain functions of a Board are best left to — may be required by law, laws such as the Sarbanes Oxley Act — independent Directors.
Board governance
The Board is governed by a Chairman of the Board and typically a Vice Chairman who stands in for the Chairman when the Chairman is not available to discharge his duties.
The Board convenes from time to time to undertake their duties and these Board meetings are typically scheduled in advance, subject to an agenda, review information prepared by management and others, documented in meeting minutes. Board decisions are documented many times in discrete Corporate Resolutions which are signed by the Board to document important decisions such as acquisitions.
Board matters require a degree of formality as they must be able to prove that their undertakings were “prudent” in order to ensure they are protected from individual liability. This is an important consideration.
Fiduciary duty
The term “fiduciary” is used to describe the nature of a duty as well as the person undertaking that duty. It is a term of art that folks like to bandy about but WTF does it really mean?
The notion of fiduciary duty is acknowledged as the HIGHEST duty an individual — a Board member — can owe to a beneficiary (shareholder) under the common law concepts known as equity. The big point — this is the highest duty you can undertake under business law. Be forewarned. Know who you serve and embrace that duty fully.
A fiduciary, an individual who undertakes such duty such as a Board member, has an obligation to embrace such simple considerations as objectivity, truthfulness, diligence, skill, responsibility, timeliness, efficiency, fairness, communication and stewardship.
These characteristics provide excellent guidelines for selecting Board members as well as a framework for discharging one’s fiduciary duty.
Recognizable standards
While the preceding paragraph sets a very high bar, the law is quite clear on some basic and fundamental standards of performance which can be enumerated as follows:
1. The duty of loyalty. The duty of loyalty and the duty of care are often referred as the “basic” duties and legal scholars will quickly identify these as the basic and very well settled legal duties of Board members. They are the font from which other recognizable duties have sprung.
The duty of loyalty is exactly what it indicates — Board members owe a fiduciary duty of loyalty to the shareholders and the company. Board members must deliberate and make decisions only in the best interests of the shareholders and the company and cannot consider their own personal interests in making such decisions. This consideration quickly invokes the concept of “conflict of interest” which is discussed further below. A Director must avoid even the appearance of a conflict in making decisions.
The duty of loyalty also guides and informs the Director when considering corporate opportunities. A Director cannot avail himself of an opportunity presented to or owned by the corporation or even related to the business of the corporation. This is a well developed and evolved doctrine that is referred to as the “corporate opportunity doctrine” which forbids a Director from even pursuing an opportunity which is only “related” to the business of the corporation.
The duty of loyalty may require a Director to make available to the corporation any opportunity which is learned of in any manner if it is related to the business of the corporation. In the case where the opportunity was the prior property of the corporation, this doctrine simply forbids pursuing that opportunity. When a Director is also a member of management — an inside Director — the duty is unambiguous and absolute. A member of management cannot purloin an opportunity learned from the corporation’s operations under any circumstances.
When such an opportunity is identical to the core business of the corporation, the conflict is so obvious and apparent as to be unimaginable that any prudent Director would consider pursuing that opportunity in any fashion. Shareholders did not elect Directors to use the corporation as a deal pipeline for their own personal gain.
2. The duty of care. The duty of care simply requires a Director to be careful in making any and all business decisions pertinent to their duties as a Director of the company. While this can be stated in just a few words, its implementation requires a bit of discussion.
A Director must be informed, deliberative, diligent and inquisitive in making decisions. These standards taken collectively might be used to define what a “prudent” man would do under similar circumstances. A Director cannot turn a “blind eye” toward making decisions. He must seek to become informed and not just accept information provided by management.
This duty creates both intellectual and process standards. Process standards require the development of a specific decision making process as well as exquisite documentation as to how the decision was made and what information was considered. Smart Boards and management rely upon a decision memorandum and a corporate resolution approving big decisions such as acquisitions.
One of the emerging concepts relating to the duty of care is the consideration that a Board and a prudent man should avoid haste or even the appearance of haste in making decisions. This concept is woven together with the duty to be both deliberative and diligent.
If a Board is considering a disposition, they must ensure that management has undertaken a rigorous price discovery mechanism — an auction — to ensure that they have arrived at the best price for the transaction and that their process taken in haste is not depriving the shareholders of a better value that might have been achieved with a less hasty process.
Boards would ensure that management is not acting in haste by carefully reviewing the potential buyers for such a disposition and ensuring that every potential party was contacted an made aware of the opportunity. In this manner, the Board is ensuring that management has conducted a price discovery auction and has, in fact, gotten the best price for the shareholders.
The deliberative process of making important decisions may require a Board to seek outside expertise or counsel in the form of a study, a fairness opinion, advice from an investment banker or public disclosure. The necessity to seek outside expertise or counsel is not only a good practice it is required when there are real or imagined conflicts involved with a specific decision.
It is too obvious to state that Boards must meet with management and probe management with questions and testing of all information supplied in support of big decisions. Once made, these decisions must be documented completely and carefully.
Management Directors should understandably recuse themselves from the final decision making for transactions or decisions which they have proposed — such as acquisitions or dispositions — or which will impact them personally.
3. The duty of disclosure. The duty of disclosure has evolved from the duty of care inasmuch as disclosure is the ultimate antiseptic. Sunlight can inoculate Boards, individual Board members and management from allegations of wrongdoing (misconduct) or sloppy administration (mismanagement) as well as ensuring that shareholders, the investing public and the stock markets are not trading while material non-public information is withheld that would and should influence such decisions.
The Board’s duty on this matter is to the shareholders not to either the management or the general public.
The duty of disclosure may be invoked before or immediately after an important decision. Seeking shareholder input on important decisions is not an uncommon action.
Sometimes this duty devolves into extremely practical considerations such as ensuring that financial statements are filed or otherwise presented in a timely and accurate manner such that all shareholders are making informed decisions based on current information.
Disclosure must be widespread and democratic. A Board cannot allow any individual or group to possess more complete or superior information or to allow a void of information to be created by omission. For public companies SEC Regulation FD (fair disclosure) addresses this specific requirement.
The classic allegation of “insider trading” is made when an individual possesses material non-public information which indicates or signals an investment decision to buy (good news) or sell (bad news) and they act on that information.
Management and entities related to management are particularly susceptible to this challenge and many companies adopt policies that insiders cannot buy or sell the company’s stock in a window before the release of earnings. This consideration becomes fatal if a company fails to timely release its earnings and management blithely trades with no information available to other shareholders.
4. The duty to resolve conflicts. Perhaps the single most important duty of the Board and one which flows directly from both the duty of loyalty and the duty of care is the necessity for a Board to ensure the resolution of conflicts of interest. Do not suggest that such conflicts are avoidable or fatal. They are real and simply have to be resolved.
The actions necessary are straightforward:
a. The Board has a duty to probe for and identify conflicts of interest. When identified, the individual Board members must give voice to their concerns. An example might be when a decision involves a “related” or “interested” party in a critical decision. When such an identification is made, the Board member has to invoke the requirement to apply “extra care” to ensure that the decision is appropriately made.
b. A Board member or member of management who has a conflict of any kind whatsoever should immediately recuse themself from the deliberations and decision making. This is not a negotiable consideration as the failure to recuse oneself may obviate certain important protections and indemnifications available to Boards.
c. A Board may require a fairness opinion or solicit an expert opinion in a matter which is fraught with peril. Fairness opinions are typically sought after a decision has been made but before it has been consummated. An expert opinion may be sought before a decision has been made.
d. A Board may insist that a special committee of only independent Directors are involved in the decision and that the committee be the one to retain experts or seek a fairness opinion and thereafter refer the matter to the Board as a whole with a definitive recommendation for the Board’s final decision or ratification. this process of forming a special committee is recognized as being a standard resolution for conflicts.
e. A Board may insist on a shareholder vote to ratify and guide important decisions. In this manner, the owners of the company (the employers of the Board) speak directly as to their wishes.
As discussed above, disclosure is a wonderful antiseptic for healing the wounds of conflict. It should be applied liberally.
5. The duty to apply extra care. We have already wandered into this subject discussing the duties above but it bears repeating that when something catches a Director’s eye, it is prudent to apply the brakes, take a deep breath and curiously delve deeper into the affair.
This is not just a good practice, it is a requirement to maintain the cloak of indemnification that is available when they are making important decisions.
This may take the form of any and all of the considerations discussed above on the duty to resolve conflicts but it also has other considerations which are more process driven. Foremost is the practice of exquisitely documenting the decision making process and the final decision itself.
The process concerns would encourage the Board to ensure that the meeting agenda, the meeting methodology, the discussion, the decision support documentation (decision memorandum) and the decision itself (corporate resolution) are convincing evidence of the prudence of their deliberations.
It would not be a bad idea to invite the company’s securities counsel to a Board meeting so that an objective and skillful third party could assure both the Board at the time of the meeting that they have met their burden and shareholders thereafter that the decision was made as suggested.
All of the above discussion is useful and helpful on the big picture. Tomorrow we shall discuss the practical considerations of putting such things into real practice and what specific tools should be employed. Stay tuned and don’t be reluctant to comment.
But, hey, what the Hell do I really know anyway? I’m just a Big Red Car. Be good to yourselves and call someone you haven’t spoken to in a long time. Bring someone some flowers tomorrow. Scare the Hell out of them.
This post first appeared at The Musings of the Big Red Car
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