Directors who serve on corporate boards often face the question: Where do I draw the line between my role and responsibilities and those of the company’s officers?
While directors typically don’t want to micromanage officers and risk usurping authority, directors also have serious oversight obligations.
Generalities about who is responsible for what on either side (for example, the board is responsible for overseeing corporate strategy and the management team is responsible for implementing operations) are not very helpful, or even entirely accurate, when it comes to determining various roles and responsibilities.
Directors should instead rely on the legal principles behind corporate law to draw distinctions between their role and that of the officers.
Directors are required to faithfully represent shareholder interests. As such, they’re subject to legal fiduciary duties. These duties have a direct impact on the division of labor between the board and management team.
The Fiduciary Duties of Board Members
Shareholders are unable to directly monitor the board of directors, making accountability tough. To address this potential problem, directors are subject to upholding fiduciary duties to shareholders, and can be held personally liable for failing to do so.
Board members have two fiduciary duties:
- The duty of care
- The duty of loyalty, which includes the duty of good faith
Duty of Care
The duty of care obligates directors to pursue diligently the interests of shareholders. This includes doing things such as:
- Overseeing the overall business direction of the company
- Obtaining information from sources other than just management
- Applying critical thinking including asking probing questions about information obtained from management
- Setting up reporting systems and internal controls that are designed to bring issues and problems to the board’s attention
- Paying attention to and taking steps to address issues that come to the board’s attention
- Conducting appropriate inquiries and investigations, as needed
Duty of Loyalty
The duty of loyalty obligates directors to act independently and avoid self-dealing.
Independence requires that a director act using sound business principles and only take into account the business issues at hand. This means excluding from consideration any personal concerns or benefits and even personal relationships.
To steer clear of self-dealing, directors must avoid situations where they personally benefit from decisions.
There may be times, however, when a board member may benefit from a set of business decisions. In these situations, there must be full disclosure of the potential conflicts, and board members should recuse themselves from the discussion.
Moreover, it needs to be the case that the board can demonstrate that a transaction with a board member (or one that benefits a board member) is at least as beneficial to the corporation as an arm’s length transaction.
A good example of where a director can have an independence issue is when the director is on a board as a representative of a particular class of shareholders who may benefit more than others from a proposed transaction.
A number of cases in recent years (for example, Calesa and Trados) have taken a tough stance on directors who do not recuse themselves and instead take actions that could be seen as benefiting themselves and the shares they “represent” (e.g. a particular series of preferred stock) to the detriment of common shareholders.
As much as courts worry about business conflicts of interest that can impair a director’s independence, courts are equally worried about social relationships that may erode a director’s independence.
This can include boss-subordinate relationships (e.g. Oracle’s acquisition of NetSuite), as well as less obvious relationships such as owning a major asset together.
Avoiding self-dealing means that if there is even a chance that something could be considered self-dealing, directors should fully disclose the relevant facts and excuse themselves from the decision-making process.
Duty of Good Faith
The duty of loyalty contains within it the duty of good faith. The duty of good faith requires that directors take action as opposed to turning a blind eye.
For example, if a director knows or has reason to believe that the CEO of a company is embezzling funds, that director has a duty to investigate, probe and ultimately stop the CEO’s activities.
The director cannot, if acting in good faith, simply ignore the CEO’s actions.
Also implicated by the duty of loyalty is the concept of good disclosure.
For example, directors have a duty to disclose conflicts or potential conflicts of interest to fellow board members. Such disclosure must be complete as well as timely.
For public companies, federal securities law also requires that the board ensure that the company is providing the public with complete and timely disclosures.
Keeping these fiduciary duties of care and loyalty in mind will further assist directors in understanding the proper scope of their oversight role. Even though fiduciary duties do not provide total clarity as to the division of labor between directors and officers, they do provide guidance.
At minimum, directors must seek, obtain, and assimilate sufficient information to uphold fiduciary duties and then act on that information.
7 Key Areas of Director Responsibility
With this understanding of a director’s role driven by its fiduciary duties, seven key areas of responsibility emerge for directors, including:
- Mergers and acquisitions
- Business direction and focus
- Company performance
- Financial statement integrity
- Capital structure
These seven key areas can be organized around the two main roles of a board of directors:
- Strategy: Overseeing strategic elements of a company, those that ultimately maximize shareholder value
- Monitoring: Monitoring the executive officers of the company
Directors can take on these seven areas without fear of improperly encroaching on the company’s officers.
Four of the seven key areas of responsibility of a director fall under strategy:
- Mergers and acquisitions
- Business direction and focus
To perform its role properly, the board must address the topic of succession for the company’s CEO and its own board members.
To protect the interests of shareholders, the board must take responsibility for hiring and potentially firing the CEO. After all, it’s the CEO who is primarily responsible for making the day-to-day decisions that directly impact the value of the company.
Directors must also consider and plan for situations where they will have to replace the CEO unexpectedly, such as if the CEO were to pass away suddenly or have poor performance.
For the same reasons that directors address CEO succession, they must also consider board succession. Retirement, death, poor performance, or the need for board refreshment are all reasons that a board will want to identify new candidates for the board.
Like succession, setting compensation is a strategic role for directors. The board should set compensation for the CEO and its own members.
Directors need to structure the CEO’s overall compensation package with appropriate incentives for the CEO to act in a way that is consistent with the goals of shareholders.
This means striking a balance between efforts to increase shareholder value while also preserving the existing value of the company.
It is also appropriate for the board to work with the CEO to outline how the rest of the employees will be compensated.
At the end of the day, however, the CEO of a company is the one who should set the salaries for employees, especially the CEO’s direct reports. Anything else would tend to disempower the CEO.
Many corporate boards delegate the task of compensation to a compensation committee. This committee undertakes the heavy lifting of reviewing CEO compensation.
However, even if a board delegates the task of setting compensation to a committee, the ultimate responsibility of compensation still rests with the full board.With respect to a director’s own compensation, there is really no way to get around the self-interested nature of this decision. Boards often find it helpful to hire an independent third party who can validate the final compensation by looking at peer benchmarking.
Public companies subject to federal securities law are required to disclose the total compensation that directors receive, which ensures that shareholders are kept aware of director compensation.If the board’s compensation is unacceptably high, the shareholders have the option to not re-elect the board.
3. Mergers & Acquisitions
Mergers, acquisitions, divestitures, and the sale of the company can have a big impact on the corporation and the shareholder’s original investment. Such activities fall outside of the normal day-to-day operations of the company.
For these reasons, oversight of M&A activities falls within the scope of the board’s role.
Directors should review all bona fide offers of major acquisitions, including offers to acquire the corporation. They should decide whether shareholders are better served by accepting the offer or by rejecting the offer.
Because of the potential for conflict of interest, the board should consider using independent third parties, such as investment bankers, to aid in the decision.
4. Business Direction and Focus
A company’s business direction and strategic focus are fundamental to the way a company creates (or in some unfortunate cases, destroys) value for shareholders.
For this reason, the board should be involved with setting the company’s strategy. Ordinarily, the CEO creates a strategy and then comes to the board for input and feedback.
The CEO and board also identify risks and obstacles to the success of the strategy. And after the strategy is set, directors should hold the CEO responsible for meeting the goals and milestones that follow.
To ensure that the CEO is focused on execution of the strategy, a board can align the CEO’s compensation with the company’s goals and milestones.
Three of the seven key areas of responsibility for directors fall into the category of monitoring:
- Company performance
- Financial statement integrity
- Capital structure
5. Company Performance
As a representative of the shareholder, directors are obligated to hold the CEO accountable for company performance. To gauge performance, the CEO and the board must first determine the key performance metrics that are most important.
Directors should continually review these metrics to understand why the company is either exceeding or failing to meet these goals.
In addition, the board should monitor that the company is performing in a legal and ethical way.
To exercise its independence, the board should regularly meet in executive session without the presence of anyone from management. This way, directors can talk freely about management. It’s a good practice to give management feedback shortly after each executive session.
Directors should also have access to professional advisers who are not otherwise engaged by the company. These advisers provide the board with an external perspective that’s unaffected by management.
6. Financial Statement Integrity
Financial statements are supposed to reflect the financial realities of a corporation.
Shareholders rely on them and expect them to be accurate. When corporate meltdowns happen due to falsified financial statements, everyone asks: “Where was the board?” and rightly so.
Although management is primarily responsible for the quality and integrity of a company’s financial statements, the board plays an important role in safeguarding that integrity.
Because directors are not involved in the day-to-day activities of a company, they cannot verify the integrity of financial statements directly. Instead, they should rely on process.
In particular, the board should ensure that the company has put in place adequate internal financial controls. These internal controls should be designed to uncover inaccurate or misleading financial information.
For example, directors should institute processes where employees can bypass the company’s ordinary reporting structure if they become aware of financial irregularities, so they can alert directly the company’s general counsel and board.
In addition, boards—or their audit committees—should hold regular meetings with the company’s auditors without management.
In these meetings, directors can question auditors on their view of the integrity of the financial statements and the company’s internal controls.
7. Capital Structure
Directors must ensure that management does not take action that inappropriately dilutes the ownership of shareholders. It is for the board to decide whether to issue new shares and determine at what price.
It’s also the board that determines whether to repurchase a company’s shares, issue warrants, and grant stock options. Directors must also ensure that any dividends issued are done so properly.
For public companies, market price generally sets the value of a share. For private companies, boards will have to do valuation exercises, often with the help of independent third-party experts.
Applying These Principles to Your Specific Company
At the end of the day, there is no bright-line test that can reveal the exact division of labor between a company’s directors and officers. Moreover, the division of labor may change over time depending on the needs of the company.
Having said that, it’s helpful to look to director fiduciary duties as a starting point or perhaps a lodestar when it comes to understanding the roles and responsibilities of directors. It is these same fiduciary duties that will also establish the appropriate scope of activity for directors in any given company.