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Board of Directors

Page history last edited by Brian D Butler 8 years, 7 months ago

Board of Directors

 


 

Lessons from the Facebook IPO

An excellent article was posted on TechCrunch talking about the unique blueprint that Facebook has demonstrated to us regarding the ability of the founder to maintain control of the board, and of the company.  All aspiring entrepreneurs should read this from TechCrunch:

 

"Now, Facebook takes the founder-control trend to the extreme. By converting his shares into a class of super-voting stock at IPO, and designating Facebook as a “controlled company,” Zuckerberg will not only control 57.1% of the vote, but will also have the legal right to name 100% of the board of directors. He can also designate whomever he chooses as the successor to his corporate authority."  read more here 

 

 

Does an Entrepreneur NEED a board of Directors? Not always...

"If i were to set up a company in Miami, I could invite people to sit on my board of directors (as advisors)....but do I really need to? Most people that set up corporations or LLC's typically do NOT have a board of directors. For example, my company (XYZ, Inc.) is a corporation, but i dont have a board of directors. I am the president, and I own all of the shares in my company (100). I dont have any need for a board of directors because I am both the owner of the shares and the manager of the company (there is no conflict of interest).

 

There only needs to be a board of directors when the owners of the company are not the same people as the managers. So, if somebody were to offer me a million dollars for my 100 shares, and I wanted to continue being the only manager....then they would want to make a board of directors to periodicaly review my work (and to make sure that I was the best person for the job). If the board thought I was not doing well, then they would replace me (in the interest of the shareholders).

 

Normally, a board of directors is assembled to represent an outside group of shareholders. Its common for somebody to be not just one one board of direcors, but on many of them. For example, Al Gore is on the Apple board of directors. He is also on the board an investment firm, and also on the board of a cable tv firm.

 

 

 

Advice for Startups & Entrepreneurs

 

Be careful how you structure your company’s board – At first, it looked smart for the One Laptop Per Child computer company to appoint an Intel representative to its board. But the partnership between Intel and OLPC hit the rocks when an Intel saleswoman tried to persuade a Peruvian official to drop the country’s commitment to buy a quarter-million of the organization’s laptops in favor of Intel PCs. NYTimes has details.

 

Boards That Are Not Bored

http://www.feld.com/blog/archives/2004/07/boards_that_are.html

 

Every large public company has a board of directors. The news is filled with stories about prominent people joining boards, about boards kicking out presidents and founders, and about personal liability of members of the boards. In a large public company, the board plays an incredibly important, and often controversial role in the governance and development of a company.

 

Given this, should a startup or small entrepreneurial company have a board of directors? I say, emphatically, YES!

 

By definition, every corporation has a board of directors. The minimum legal size of the board varies by state. In some states, the minimum size is three people (typically a president, secretary, and treasurer--also referred to as the officers of the company). In other states, the minimum size is linked to the number of shareholders--if there is only one equity holder in the corporation, there only needs to be one board member. Of course, there are several different types of companies, such as partnerships or sole proprietorships that do not require a formal board.

 

For many companies, the board of directors ends up being the founders of the company. However, I believe there is huge value in expanding the board to include "outside" directors--those that do not work for the company, but offer their time and advice to help shape and guide the company. These outside directors serve a similar function to those of a public company, but often with a much different approach.

 

It is important not to get a board of directors confused with a board of advisors or a strategic advisory board. These other boards are incredibly valuable tools for a company, but they serve a dramatically different purpose which I will discuss in a separate article.

 

I have been a member of many boards of directors and I have come to classify each board as one of three different types:

 

Working Boards: These are boards that role up their sleeves and help the founders and management team of the company get the job done. They meet frequently, have animated, engaged discussions, and offer significant ongoing support and help to the key owners and managers of the company.

Reporting Boards: These are boards that meet four to six times a year for a status report on the company. If everything is going well, they tend not to have much to say. If there are problems or issues, they are often critical of the CEO and the management team. If things continue to go poorly, they often take action of some sort.

Lame Duck Boards: These are boards that have no influence on the company. In many cases, they are simply rubber stamp exercises for the CEO or founders.

The only type of board that I believe is useful for a small, entrepreneurial company is a working board. The pressures in an entrepreneurial company are great enough that the founders and the management team need everyone involved doing everything they can to make the company successful. This does not mean that everyone agrees on everything, or the members of the board are not critical of the management team. But, it does mean that there is an active, open commitment to work with the founders and management team to make the company succeed wildly.

 

Board members come in many shapes and sizes. In my experience, a good size of a board is five to seven people, including the insiders. If there are only one or two insiders on the board, a total board size of five is plenty. If there are more than two insiders on the board, seven board members is more appropriate. I recommend that several of the outside board members be highly experienced entrepreneurs in the market that the company is going after. The rest of the board members should be experienced entrepreneurs in other business segments, but with a particular interest in something about the company.

 

The chairman of the board is often one of the insiders, such as the president or CEO. However, in many cases, you may want the chairman to be one of the outsiders, especially in a situation where one of the outsiders helped start the company by putting up some of the initial seed capital. The role of the chairman varies dramatically, but it often raises the level of commitment of the individual board member that is the chairman and the overall board in general.

 

Significant outside investors, especially venture capitalists, will want board seats. I recommend you limit the number of outside investors on your board, unless they fit the criteria listed above. A venture investor only needs one board seat - if you have a syndicate of venture investors (several different venture capitalists that invested together in the round), consider offering one board seat and extending observer rights (e.g. the right to attend any board meeting) to the other investors. These rights should be negotiated as part of the investment.

 

In addition to functioning as a regular sounding board for the management team, board members can contribute substantially to the business, both as a group and individually. Board members can be incredibly useful during financings, merger and acquisition activity, general corporate strategy, and executive recruiting. Do not overlook the experiences and skills of each of the individual board members--they can often play high value, short term consulting roles as needed.

 

Board members should be compensated for their efforts. At the minimum, their travel expenses should be paid. Most entrepreneurial companies should set up an option package for the board members - depending on the level of effort requested of the board, this could be as little as 0.25 percent of the company or as much as 2 percent of the company vesting over four years. In addition, many board members are interested and willing to invest in the company. I always believe that it is in the best interest of a company to have the board members have a meaningful equity stake in the company.

 

In some cases, the directors that you recruit will have a substantial personal net worth. In these cases, they might ask if the company has "Director and Officers Insurance" (D&O Insurance). This is insurance that protects the director from having personal liability in case the company gets sued. Small companies cannot afford D&O insurance (in fact, most private companies cannot afford this), while most public companies must have this as a requirement of the underwriters in an initial public offering. So, when confronted with the question, the best solution is to make sure that the articles of incorporation of the company provide the directors with the highest limitation on liability afforded by the state the company is incorporated in. Don't waste your time investigating D&O pricing - it won't be economical.

 

Finally, take good care of your board members. These are busy folks that are making a substantial time and energy commitment to you. They share in the rewards if you are successful, but their time and energy is at risk since their primary form of compensation is equity in your company. Feed them. Make them comfortable. Have fun together! You'll be pleasantly surprised how much faster the relationships evolve and how much more valuable they become when everyone is working hard, but having a good time together. Don't ever let your board get bored

 

 

 

 

 

Create a board that reflects the ownership of the company

http://www.venturehacks.com/articles/board-structure

 

“Good boards don’t create good companies, but a bad board will kill a company every time.”

 

– Old Silicon Valley Saying

 

Summary: Create a board of directors that reflects the ownership of the company and don’t let your investors control the board through an independent board seat.

 

The composition of the board of directors is the most important element of the Series A investment. It is more important than the valuation of your company.

 

The valuation of your company won’t matter to you if the board

 

Terminates you and you lose your unvested stock.

Forces the company to raise a low-valuation Series B from existing investors by rejecting offers until the company is almost out of cash.

Merges the company with another private company and wipes out your common stock in the process.

If it isn’t obvious by now, a bad board can do lots of stupid or malicious things to make your stock or company worthless.

 

The board you create will be your new boss. But trying to please everyone on your board dooms you to managing board members and ignoring customers and employees. Great companies are rarely built by committee and a bad board will waste your time trying to run the company their way.

 

This hack will show you how to create a board of directors that you can trust even when you don’t agree with its decisions.

 

The board should reflect the ownership of the company.

The form of government in a company is dictatorship. The board represents the owners of the company and selects the dictator (CEO). The board then works to ensure the dictator is optimally benevolent towards the owners. Naturally, bad dictators get beheaded…

 

If the board represents the owners of the company, its composition should reflect the ownership of the company. Truly competitive and transparent markets, such as the public stock markets, have already reached this conclusion.

 

After the Series A investment has closed, the common stockholders are probably going to own most of the company. The common stockholders should therefore elect most of the board seats. Let’s assume the common stockholders own approximately 60% of the company after the Series A. If you’re taking money from two investors, the board should look like

 

3 common + 2 investors = 5 members.

 

And if you’re taking money from one investor, the board should look like

 

2 common + 1 investor = 3 members.

 

In either case, the common stock should elect its directors through plurality voting. Plurality voting enables the founders to elect all of the common seats if they control a majority of the common stock.

 

The sound bite you want to use in your negotiation is

 

“The common stock owns most of the company. Isn’t ownership the basis for determining the composition of the board? One share, one vote?”

 

Your investors may argue that this board structure leaves their preferred stock exposed to the machinations and malfeasance of the common board members. Your response should be

 

“Isn’t that why we’re giving you protective provisions?”

 

Early-stage companies with good leverage can negotiate this democratic board structure in a Series A. If your investors tell you that a democratic board is a deal-breaker and you want to move forward with them, use the fallback position: an investor-leaning board.

 

Don’t settle for anything less than an investor-leaning board.

An investor-leaning board looks like this:

 

2 investors: 2 common + 2 investors + 1 independent = 5 seats

 

or

 

1 investor: 1 common + 1 investor + 1 independent = 3 seats.

 

An investor-leaning board gives an equal number of seats to every class of stock, no matter how many shares that class owns. This makes no sense, but, hey! that’s venture capital! There are many future scenarios where your investors can take over this board (e.g. a down round or hiring a new CEO), but there are no realistic scenarios where the common stockholders take over this board. Hence, this board is investor-leaning.

 

If you end up with an investor-leaning board, get your investors to agree to create a new common seat anytime the company creates a new investor seat (e.g. for the Series B investor). This prevents the investors from taking over the board in the Series B as long as this term isn’t renegotiated.

 

If you have a strong BATNA, you should reject anything less than an investor-leaning board. If your prospective investors suggest anything worse, they are probably trying to take advantage of you.

 

Fill the independent seat with an independent party.

Don’t let the investors control the board through the independent seat. They may suggest a big shot for the independent seat whom you can’t decline without looking like a fool.

 

But the big shot does a lot more business with VCs than he is likely to do with you. VCs regularly refer the big shot to promising companies. The big shot invests in various venture funds and startups that the VCs send his way. Perhaps the big shot was an entrepreneur-in-residence at the investor’s firm. Where do you think the big shot’s loyalties lie?

 

Most likely, the big shot will be aligned with your investors.

 

The simplest solution to this dilemma is to fill the independent seat before the financing. At a minimum, select someone whom you trust and has the credibility to fill the seat. The investors will have a tough time replacing this independent director if your selection is a big shot himself or if he introduced the company to the venture firm in the first place.

 

If you can’t select the independent director until after the financing, the simplest solution is to

 

Select the independent director by the unanimous consent of the board members. (Who could argue with this?)

Tell the investors that you, like them, are going to be very picky about the independent director.

Take control of the situation immediately by suggesting names for the independent director

 

 

Make a new board seat for a new CEO

 

http://www.venturehacks.com/articles/ceo-board-seat

 

“Because we weren’t having success finding a CEO, our investors insisted that we hire these managers a temporary CEO and CFO. That didn’t go great.”

 

– Tim Brady, 1st employee at Yahoo, Founders at Work

 

Summary: Create a new board seat for a new CEO. Don’t give him one of the common seats.

 

Whether you negotiate a proportional or investor-leaning board, your term sheet will probably state that the CEO of the company must fill one of the common board seats. This may seem reasonable. One of the founders is probably the CEO and you were going to elect him to the board anyway.

 

Don’t accept this term. The investors are looking several moves ahead of you.

 

If you accept this term and hire a new CEO, he will take one of the common seats. The common shareholders will not have the right to elect that seat. If the new CEO turns out to be aligned with the investors, the new coalition of CEO + investors will control the board of directors.

 

A new CEO may be aligned with the investors.

A new CEO will probably be a professional manager who does a lot more business with VCs than he is likely to do with you.

 

VCs regularly refer the CEO to promising companies. They let him co-invest in their startups. They let him invest in their venture funds. They determine his compensation in your company. Where do you think the CEO’s loyalties lie?

 

Most likely, a new CEO will be aligned with the investors.

 

A coalition of CEO + investors can hurt the company.

A coalition of a new CEO + investors can hurt the company, founders, and employees. Consider this scenario:

 

The company needs to raise a Series B. Your investors discourage the new CEO from shopping around for cash because they want to invest more money in the business at a low valuation. Your investors tell you not to spend time raising cash because they will put in more money: “You should focus on building the business.” You want to shop around and raise money at a high valuation but the CEO does a half-arsed job because he knows this game.

 

The company ends up doing the Series B with its existing investors because that is the best offer on the table. A few months later, the CEO’s shares are “right-sized” and he is happy (“We have to pay the CEO market rates, right?”). The investors have put in more money at a low valuation and they are happy. The founders and employees have been diluted and they are wondering what just happened.

 

This story is not unheard of in Silicon Valley.

 

A new CEO may be naturally inclined to dilute you.

A new CEO can develop an antagonistic relationship with the company’s founders. Founders, like everyone else, have inadequacies as leaders and managers. Their inadequacies are usually worse than the ones the company portrayed while it was recruiting and selling the new CEO.

 

The new CEO joins the company and naturally blames the founders for all of the existing problems in the business. Who else is there to blame? Like any new leader, he continues to blame his predecessor for the next 12 months and loses any sympathy he had for the founders. He convinces himself that he deserves more equity for his contributions even if it dilutes the founders and employees.

 

“These fucking founders,” he tells the investors.

 

“Yes, these fucking founders,” say the investors.

 

And on they go to find to find a mutually beneficial opportunity to right-size the CEO.

 

Create a new board seat for a new CEO.

These two tales of CEO-investor intrigue illustrate why a new CEO is not necessarily your friend on the board of directors. If and when you hire a new CEO, create a new board seat for him. The common board seats should always be elected by the common shareholders.

 

For example, adding a CEO seat to an investor-leaning board with two investors yields

 

2 common + 2 investors + 1 independent + 1 CEO = 6 seats

 

The same scenario with one investor yields

 

1 common + 1 investor + 1 independent + 1 CEO = 4 seats

 

If you want to keep an odd number of people on the board, add another independent seat too.

 

If you have a good BATNA, you should reject any proposal where the CEO takes one of the common board seats.

 

The new CEO seat maintains the board’s structure (if you’re lucky).

Your investors may argue that the new CEO seat tips the board in favor of the common stockholders since the CEO holds common stock.

 

If only you were so lucky.

 

If your investors accept the premise that the new CEO is probably aligned with them, the new seat actually tips the board in their favor. If they don’t accept this premise, they are still wrong.

 

First, the independent director holds common stock, but the investors do not consider his seat to tip the board in favor of the common stockholders. You should ask your investors to consistently apply the same reasoning to the new CEO seat.

 

Second, the CEO does not represent the common stockholders on the board; his job is to create value for all classes of stock. In fact, all of the board members have a duty to serve the interests of the company, not a duty to “serve their class of stock”.

 

You learn a lot about an investor’s attitude toward directorship if they imply that they represent their class of stock on the board. Investors should protect their class of stock through protective provisions, not through their board seat.

 

 

Board of Directors agreement

http://www.feld.com/blog/archives/2005/01/term_sheet_boar.html

 

A typical term sheet looks as follows:

 

Board of Directors: The size of the Company’s Board of Directors shall be set at (n). The Board shall initially be comprised of ____________, as the Investor representatives _______________, _________________, and ______________. At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect (x) member (s) of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect (x) members, and the remaining directors will be (Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class.) ( or Option 2: chosen by the mutual consent of the Board of Directors).

 

If a subset of the board is being chosen by more than one constituency (e.g., two directors chosen by the investors, two by founders / common holders and one by “mutual consent”), you should consider what is best: (a) chosen my mutual consent of the board (one person, one vote) or (b) voted upon on the basis of proportional share ownership on a common-as-converted basis.

 

VCs will often want to include a board observer as part of the agreement either instead of or in addition to an official member of the board. This is typical and usually helpful, as many VC partners have an associate that works with them on their companies. While there’s rarely any contention about who attends a board meeting, most VCs will want the right to have another person from the firm at the board meeting, even if they are non-voting (an “observer”).

 

Many investors will mandate that one of the common-stockholder chosen board members be the then-serving CEO of the company. This can be tricky if the CEO is the same as one of the key founders – often you’ll see language giving the right to a board seat to one of the founders and a separate board seat to the then CEO – consuming two of the common board seats. Then – if the CEO changes, so does that board seat.

 

While it is appropriate for board member and observers to be reimbursed for their reasonable out-of-pocket costs for attending board meetings, we rarely see board members receive cash compensation for serving on the board of a private company. Outside board members are usually compensated with stock options – just like key employees – and are often invited to invest money in the company alongside the VCs.

 

 

More info from Wikipedia

 

In relation to a company, a director is an officer of the company charged with the conduct and management of its affairs. The directors collectively are referred to as a board of directors. Sometimes the board will appoint one of its number to be the chairman of the board.

 

Theoretically, the control of a company is divided between two bodies: the board of directors, and the shareholders in general meeting. In practice, the amount of power exercised by the board varies with the type of company. In small private companies, the directors and the shareholders will normally be the same people, and thus there is no real division of power. In large public companies, the board tends to exercise more of a supervisory role, and individual responsibility and management tends to be delegated downward to individual professional executive directors who deal with particular areas of the companies affairs (such as a finance director, a marketing director, etc.).

 

Another feature of boards of directors in large public companies is that the board tends to have more de facto power. Between the practice of institutional shareholders (such as pension funds and banks) to grant proxies to the board to vote their shares at general meetings, and the large numbers of shareholders involved, the board can comprise a voting block that is difficult to overcome. However, there have been moves recently to try and increase shareholder activism amongst both institutional investors and individuals with small shareholdings

 

 

Classification

 

 

 

Directors are traditionally divided into executive directors and non-executive directors. Broadly, executive directors tend to be persons who are dedicated full-time to their role in relation to the management of the company. Non-executive directors tend to be "outsiders" brought in for their expertise, and to lend a more impartial view in relation to strategic decisions. Many corporate reforms in the late 1990s and early 2000s were focused on increasing the number and role of non-executive directorships in public companies in the belief that an impartial view was more likely to restrain corporate excess and egos and reduce the likelihood of another major corporate scandal. This view is not new; similar recommendations were made by the Cadbury Committee in the United Kingdom in 1992.1

 

In practice, executive directors tend to dominate board meetings simply by virtue of their much greater familiarity with the company and its internal workings.

 

Some countries also classify persons who are not actually directors as either de facto directors, or "shadow" directors. A de facto director is a person who is not actually appointed as a director, but acts as if he were (often because he wrongly believes that he has been properly appointed as a director). A "shadow" director is also not a director at all, but seeks to control the direction and management of the company without putting himself forward as being able to do so

 

History

 

The development of a separate board of directors to manage the company has occurred incrementally and indefinitely over legal history. Until the end of the nineteenth century, it seems to have been generally assumed that the general meeting was the supreme organ of the company, and the board of directors was merely an agent of the company subject to the control of the shareholders in general meeting.3

 

By 1906 however, the English Court of Appeal had made it clear in the decision of Automatic Self-Cleansing Filter Syndicate Co v Cunningham 1906 2 Ch 34 that the division of powers between the board and the shareholders in general meeting depended upon the construction of the articles of association and that, where the powers of management were vested in the board, the general meeting could not interfere with their lawful exercise. The articles were held to constitute a contract by which the members had agreed that "the directors and the directors alone shall manage."4

 

The new approach did not secure immediate approval, but it was endorsed by the House of Lords in Quin & Artens v Salmon 1909 AC 442 and has since received general acceptance. Under English law, successive versions of Table A have reinforced the norm that, unless the directors are acting contrary to the law of the provisions of the Articles, the powers of conducting the management and affairs of the company are vested in them.

 

The modern doctrine was expressed in Shaw & Sons (Salford) Ltd v Shaw 1935 2 KB 113 by Greer LJ as follows:

 

"A company is an entity distinct alike from its shareholders and its directors. Some of its powers may, according to its articles, be exercised by directors, certain other powers may be reserved for the shareholders in general meeting. If powers of management are vested in the directors, they and they alone can exercise these powers. The only way in which the general body of shareholders can control the exercise of powers by the articles in the directors is by altering the articles, or, if opportunity arises under the articles, by refusing to re-elect the directors of whose actions they disapprove. They cannot themselves usurp the powers which by the articles are vested in the directors any more than the directors can usurp the powers vested by the articles in the general body of shareholders."

 

It has been remarked that this development in the law was somewhat surprising at the time, as the relevant provisions in Table A (as it was then) seemed to contradict this approach rather than to endorse it.5

 

Election and removal

 

In most legal systems, the appointment and removal of directors is voted upon by the shareholders in general meeting

 

Directors may also leave office by resignation or death. In some legal systems, directors may also be removed by a resolution of the remaining directors (in some countries they may only do so "with cause"; in others the power is unrestricted).

 

Some jurisdictions also permit the board of directors to appoint directors, either to fill a vacancy which arises on resignation or death, or as an addition to the existing directors.

 

In practice, it can be quite difficult to remove a director by a resolution in general meeting. In many legal systems the director has a right to receive special notice of any resolution to remove him;7 the company must often supply a copy of the proposal to the director, who is usually entitled to be heard by the meeting.8 The director may require the company to circulate any representations that he wishes to make.9 Furthermore, the director's contract of service will usually entitle him to compensation if he is removed, and may often include a generous "golden parachute" which also acts as a deterrent to removal.

 

Exercise of powers

 

The exercise by the board of directors of its powers usually occurs in meetings. Most legal systems provide that sufficient notice has to be given to all directors of these meetings, and that a quorum must be present before any business may be conducted. Usually a meeting which is held without notice having been given is still valid so long as all of the directors attend, but it has been held that a failure to give notice may negate resolutions passed at a meeting, as the persuasive oratory of a minority of directors might have persuaded the majority to change their minds and vote otherwise.10

 

In most common law countries, the powers of the board are vested in the board as a whole, and not in the individual directors.11 However, in instances an individual director may still bind the company by his acts by virtue of his ostensible authority (see also: the rule in Turquand's Case).

 

Duties

 

Because directors exercise control and management over the company, but companies are run (in theory at least) for the benefit of the shareholders, the law imposes strict duties on directors in relation to the exercise of their duties. The duties imposed upon directors are fiduciary duties, similar in nature to those that the law imposes on those in similar positions of trust: agents and trustees.

 

In relation to director's duties generally, two points should be noted:

 

1. the duties of the directors are several (as opposed to the exercise by the directors of their powers, which must be done jointly); and

2. the duties are owed to the company itself, and not to any other entity.12 This doesn't mean that directors can never stand in a fiduciary relationship to the shareholders; they may well have such a duty in certain circumstances.13

 

"Acting in good faith"

 

Directors must act honestly and in good faith. The test is a subjective one - the directors must act "bona fide in what they consider - not what the court may consider - is in the interests of the company... "14 However, the directors may still be held to have failed in this duty where they fail to direct their minds to the question of whether in fact a transaction was in the best interests of the company.15

 

Difficult questions can arise when treating the company too much in the abstract. For example, it may be for the benefit of a corporate group as a whole for a company to guarantee the debts of a "sister" company,16 even though there is no ostensible "benefit" to the company giving the guarantee. Similarly, conceptually at least, there is no benefit to a company in returning profits to shareholders by way of dividend. However, the more pragmatic approach illustrated in the Australian case of Mills v Mills (1938) 60 CLR 150 normally prevails:

 

"directors are not required by the law to live in an unreal region of detached altruism and to act in the vague mood of ideal abstraction from obvious facts which must be present to the mind of any honest and intelligent man when he exercises his powers as a director."

 

"Proper purpose"

 

Directors must exercise their powers for a proper purpose. Whilst in many instances an improper purpose is readily evident, such as a director looking to feather his or her own nest or divert an investment opportunity to a relative, such breaches usually involve a breach of the director's duty to act in good faith. Greater difficulties arise where the director, whilst acting in good faith, is serving a purpose that is not regarded by the law as proper.

 

The seminal authority in relation to what amounts to a proper purpose is the Privy Council decision of Howard Smith Ltd v Ampol Ltd 1974 AC 832. The case concerned the power of the directors to issue new shares. It was alleged that the directors had issued a large number of new shares purely to deprive a particular shareholder of his voting majority. An argument that the power to issue shares could only be properly exercised to raise new capital was rejected as too narrow, and it was held that it would be a proper exercise of the director's powers to issue shares to a larger company to ensure the financial stability of the company, or as part of an agreement to exploit mineral rights owned by the company.17 If so, the mere fact that an incidental result (even if it was a desired consequence) was that a shareholder lost his majority, or a takeover bid was defeated, this would not itself make the share issue improper. But if the sole purpose was to destroy a voting majority, or block a takeover bid, that would be an improper purpose.

 

Not all jurisdictions recognised the "proper purpose" duty as separate from the "good faith" duty however.18

 

"Unfettered discretion"

 

Directors cannot, without the consent of the company, fetter their discretion in relation to the exercise of their powers, and cannot bind themselves to vote in a particular way at future board meetings.19 This is so even if there is no improper motive or purpose, and no personal advantage to the director.

 

This does not mean, however, that the board cannot agree to the company entering into a contract which binds the company to a certain course, even if certain actions in that course will require further board approval. The company remains bound, but the directors retain the discretion to vote against taking the future actions (although that may involve a breach by the company of the contract that the board previously approved).

 

"Conflict of duty and interest"

 

As fiduciaries, the directors may not put themselves in a position where their interests and duties conflict with the duties that they owe to the company. The law takes the view that good faith must not only be done, but must be manifestly seen to be done, and zealously patrols the conduct of directors in this regard; and will not allow directors to escape liability by asserting that his decision was in fact well founded. Traditionally, the law has divided conflicts of duty and interest into three sub-categories.

 

Transactions with the company

 

By definition, where a director enters into a transaction with a company, there is a conflict between the director's interest (to do well for himself out of the transaction) and his duty to the company (to ensure that the company gets as much as it can out of the transaction). This rule is so strictly enforced that, even where the conflict of interest or conflict of duty is purely hypothetical, the directors can be forced to disgorge all personal gains arising from it. In Aberdeen Ry v Blaikie (1854) 1 Macq HL 461 Lord Cranworth stated in his judgment that:

 

"A corporate body can only act by agents, and it is, of course, the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting. Such agents have duties to discharge of a fiduciary nature towards their principal. And it is a rule of universal application that no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting or which possibly may conflict, with the interests of those whom he is bound to protect... So strictly is this principle adhered to that no question is allowed to be raised as to the fairness or unfairness of the contract entered into..." (emphasis added)

 

However, in many jurisdictions the members of the company are permitted to ratify transactions which would otherwise fall foul of this principle. It is also largely accepted in most jurisdictions that this principle should be capable of being abrogated in the company's constitution.

 

In many countries there is also a statutory duty to declare interests in relation to any transactions, and the director can be fined for failing to make disclosure.20

 

Use of corporate property, opportunity, or information

 

Directors must not, without the informed consent of the company, use for their own profit the company's assets, opportunities, or information. This prohibition is much less flexible that the prohibition against the transactions with the company, and attempts to circumvent it using provisions in the articles have met with limited success.

 

In Regal (Hastings) Ltd v Gulliver 1942 All ER 378 the House of Lords, in upholding what was regarded as a wholly unmeritorious claim by the shareholders,21 held that:

 

"(i) that what the directors did was so related to the affairs of the company that it can properly be said to have been done in the course of their management and in the utilisation of their opportunities and special knowledge as directors; and (ii) that what they did resulted in profit to themselves."

 

And accordingly, the directors were required to disgorge the profits that they made, and the shareholders received their windfall.

 

The decision has been followed in several subsequent cases,22 and is now regarded as settled law.

 

Competing with the company

 

Directors cannot, clearly, compete directly with the company without a conflict of interests arising. Similarly, they should not act as directors of competing companies, as their duties to each company would then conflict with each other.23

 

In practice, it is not wholly unusual to see directors serve for two or more companies in competing fields, but it is tacitly assumed that they may only do so if the companies consent.

 

Common law duties of care and skill

 

Traditionally, the level of care and skill which has to be demonstrated by a director has been framed largely with reference to the non-executive director. In Re City Equitable Fire Insurance Co 1925 Ch 407, it was expressed in purely subjective terms, where the court held that:

 

"a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience." (emphasis added)

 

However, this decision was based firmly in the older notions (see above) that prevailed at the time as to the mode of corporate decision making, and effective control residing in the shareholders; if they elected and put up with an incompetent decision maker, they should not have recourse to complain.

 

However, a more modern approach has since developed, and in Dorchester Finance Co v Stebbing 1989 BCLC 498 the court held that the rule in Equitable Fire related only to skill, and not to diligence. With respect to diligence, what was required was:

 

"such care as an ordinary man might be expected to take on his own behalf."

 

This was an objective test, and one deliberately pitched at a higher level.

 

More recently, it has been suggested that both the tests of skill and diligence should be assessed objectively.24

 

Remedies for breach of duty

 

In most jurisdictions, the law provides for a variety of remedies in the event of a breach by the directors of their duties:

 

1. injunction or declaration

2. damages or compensation

3. restoration of the company's property

4. rescission of the relevant contract

5. account of profits

6. summary dismissal

 

The future

 

Historically, director's duties have been owed almost exclusively to the company and its members, and the board was expected to exercise its powers for the financial benefit of the company. However, more recently there have been attempts to "soften" the position, and provide for more scope for directors to act as good corporate citizens. For example, in the United Kingdom, The Companies Act 2006, not yet in force, will require a director of a UK company "to promote the success of the company for the benefit of its members as a whole", but sets out six factors to which a director must have regards in fulfilling the duty to promote success. These are:

 

  • 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 as between members of a company

 

This represents a considerable departure from the traditional notion that directors' duties are owed only to the company. Under the Companies Act 1985, protections for non-member stakeholders were considerably more limited (see e.g. s.309 which permitted directors to take into account the interests of employees but which could only be enforced by the shareholders and not by the employees themselves. The changes have therefore been the subject of some criticism. 3

 

Failures

 

While the primary responsibility of boards is to ensure that the corporation's management is performing its job correctly, actually achieving this in practice can be difficult. In a number of "corporate scandals" of the 1990s, one notable feature revealed in subsequent investigations is that boards were not aware of the activities of the managers that they hired, and the true financial state of the corporation. A number of factors may be involved in this tendency:

 

  • Most boards largely rely on management to report information to them, thus allowing management to place the desired 'spin' on information, or even conceal or lie about the true state of a company.
  • Boards of directors are part-time bodies, whose members meet only occasionally and may not know each other particularly well. This unfamiliarity can make it difficult for board members to question management.
  • CEOs tend to be rather forceful personalities. In some cases, CEOs are accused of exercising too much influence over the company's board.
  • Directors may not have the time or the skills required to understand the details of corporate business, allowing management to obscure problems.
  • The same directors who appointed the present CEO oversee his or her performance. This makes it difficult for some directors to dispassionately evaluate the CEO's performance.
  • Directors often feel that a judgement of a manager, particularly one who has performed well in the past, should be respected. This can be quite legitimate, but poses problems if the manager's judgement is indeed flawed.
  • All of the above may contribute to a culture of "not rocking the boat" at board meetings.

 

Because of this, the role of boards in corporate governance, and how to improve their oversight capability, has been examined carefully in recent years, and new legislation in a number of jurisdictions, and an increased focus on the topic by boards themselves, has seen changes implemented to try and improve their performance.

 

Sarbanes-Oxley Act

 

In the United States, the Sarbanes Oxley Act (SOX) has introduced new standards of accountability on the board of directors. Members now risk large fines and prison sentences in the case of accounting crimes. Internal controls are now the direct responsibility of directors. This means that the vast majority of public companies now have hired internal auditors to ensure that the company adheres to the highest standards of internal controls. Additionally, these internal auditors are required by law to report directly to the audit board. This group consists of board of directors members where more than half of the members are outside the company and one of those members outside the company is an accounting expert.

 

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