Leverage Effective Counsel to Influence Changes and Impact Business Performance

David M. Loev, JD and CPA

Leverage Effective Counsel to Influence Changes and Impact Business Performance

Learning Objectives:

Importance of involving counsel to be proactive in establishing controls that reduce risk and influence change to increase business results

 Definition of Corporate Governance

 “Corporate Governance refers to the way in which companies are governed and to what purpose. It identifies who has power and accountability, and who makes decisions. It is, in essence, a toolkit that enables management and the board to deal more effectively with the challenges of running a company. Corporate governance ensures that businesses have appropriate decision-making processes and controls in place so that the interests of all stakeholders (shareholders, employees, suppliers, customers and the community) are balanced.”[1]

 Corporate governance applies to both the Board of Directors of a company, which has the primary role for oversight and accountability and officers, who are tasked with implementing the plans approved by the Board of Directors – ideally with the input of management.

 Role of Counsel In Representation of Corporate Clients

 The client of a lawyer who has been engaged to represent a corporation is the corporation itself and not its management or Board of Directors. Lawyers should always keep that in mind in their representation. Executive officers of a corporate client often believe that they are the clients of the attorney – because they are typically an attorney’s main contacts and because of the personal relationships that develop with such individuals – and not the corporation. In certain matters, like the negotiation of employment contracts and compensation issues, attorneys need to walk a tightrope between possibly offending the officer’s whose compensation is being discussed with the Board of Directors, and who are most often the ones responsible for hiring and firing attorneys, and their duty to the corporation as a whole.

In situations like this, and where conflicts of interest arise between the corporation, its officers and directors, it is best if each group in conflict obtains its own legal counsel to avoid any conflicts of interest.

Attorney as Gatekeeper

The Securities and Exchange Commission and other government agencies have previously argued that attorneys are ‘gatekeepers’, with the power to keep their clients from violating securities and other laws. While that designation would require among other things, that clients always listen to and take the advice of their legal counsel, something that rarely happens in the real world, it is important to keep the ‘gatekeeper’ designation in the back of your mind during corporate representation. I.e., that an attorney could be held liable for the actions of its corporate client. The first part of this presentation will discuss some ways that corporate legal counsel can be pro active in establishing strong corporate governance checks and balances to protect not only the client/corporation, but also the attorney.

Proper Engagement of Outside Counsel

Often, we find that companies (especially smaller companies and private companies) are reluctant to use attorneys to negotiate contracts and term sheets on their behalf. Generally, this occurs because the companies (1) think engaging an attorney or paying for the attorney’s time will be too expensive; (2) feel the need to enter into agreements and/or accept the terms of the counterparty immediately; or (3) believe they can negotiate contracts themselves.

Typically, this results in one-sided agreements being agreed to and/or terms being approved which result in significant issues which the company didn’t anticipate as time passes. Additionally, in the case of a term sheet, this can result in the client agreeing to terms which are below market and which could have easily been approved with the help of counsel – generally once agreed to in a term sheet it is difficult, if not impossible, to have a counter party agree to less favorable terms.

The most important thing we tell our clients is that while they may be on good terms with the counterparties to the agreements now, there may come a time when a conflict arises, the persons in charge of the counterparties change, or when one party fails to meet their requirements under the agreement. The goal of an attorney is to draft an agreement which considers all of those contingencies and protects each party when/if issues arise.

We routinely have long-time clients come to us with agreements which we never reviewed or provided guidance on asking us how they can get out of bad deals. Unfortunately, what we often realize from reviewing the agreements is that there are no ‘outs’ and our clients are trapped in the agreements, often time for several years. What typically happens in these situations is that clients end up spending more money on legal fees to get out of bad agreements then they would have spent to have a competent attorney review their agreements on the front end and draft for potential contingencies and ‘outs’.

As such, part of being proactive with corporate governance means knowing when business functions should be outsourced to professionals. While anyone can negotiate a legal contract, corporate attorneys, employment attorneys and intellectual property attorneys (just as examples), have specialized knowledge and experience with deal terms and customary agreement provisions which generally lead to a more detailed and fairer contractual outcome for the company. We have found that these types of specialized engagements are well worth their expense.

Similarly, outsourcing things like regulatory compliance, payroll and accounting, while more expensive than doing those things in-house, generally means that companies have persons/entities in charge of each of those functions who are experts in those matters, deal with those matters on a daily basis and are going to be able to more effectively manage any issues which arise. As part of managing controls and minimizing risk, an added benefit to outsourcing these functions is that there is a hopefully an impartial and unrelated set of eyes looking into those matters (especially things like accounting, which can unfortunately sometimes lead to issues with embezzlement if left unchecked). Finally, if issues do arise with service providers and their services – for example if regulators challenge the company’s accounting practices or regulatory compliance – the company will be at least partially insulated from liability and may be due indemnification from such service providers for their negligence or misdeeds.

Major corporate actions should be discussed with counsel prior to approval by the Board and/or the Board should approve such matters, contingent upon review and approval by counsel. We have had situations where Board’s decide mid-meeting to change their fiscal year, change auditors or issue shares, and take actions to approve those transactions at the same meeting without contingencies. Unfortunately, all of those transactions were undertaken by public companies (which are required to follow strict disclosure requirements), which, because such transactions were approved outright by the Boards, required public disclosure of the events and approvals, even though after further discussion between counsel and the Board, it was deemed in the best interests of the companies to not move forward with those transactions.

Public companies and exchange/Nasdaq related companies have to be even more diligent about obtaining pre-clearance/pre-approval for corporate transactions outside the usual course of business as not to trigger any unintended disclosure obligations or violations of exchange rules. We suggest that legal counsel be provided a copy of the proposed agenda before each Board meeting and that legal counsel participate in all major Board meetings so that potential issues and disclosure items can be identified and discussed prior to Board approval. What we find is that there can sometimes be a rush by the Board to approve things when it has been difficult to get all of the Board members together on a call or at a meeting, and we recommend in those situations that the Board provide the officers discretion to undertake the transaction and negotiate the final terms, only after further discussion with legal counsel.

It is also imperative that counsel be provided a heads up on any material transactions and issuances of securities so that counsel can confirm that such transactions and issuances are properly approved under applicable state and federal law statutes, contingent where applicable on shareholder approval, and structured to comply with federal and state securities laws, where applicable.

When in doubt, all material corporate transactions should be run by competent counsel prior to approval by the Board, or the officers, to avoid unintended issues and disclosure obligations.

Understanding the board of directors responsibility and the lawyer’s role in corporate governance

There are numerous corporate governance polices and ‘best practices’, which if implemented help to reduce risk and increase business results.

Majority Independent Directors

By requiring the Board of Directors of a corporation to maintain a majority of ‘independent’ directors on the Board of Directors (something that the major stock exchanges and Nasdaq already require), the Board can significantly limit related party conflicts and conflicts of interest. Counsel should provide assistance to the Board in connection with the determination of whether or not members of the Board are ‘independent’ and when circumstances change, determinations of whether previously ‘independent’ members are no longer ‘independent.’ It is important to involve counsel early in the process of appointing/nominating director candidates so that proper assistance can be provided to the Board on the front end to determine whether or not candidates would qualify as ‘independent’ before the process moves too far along.

Typically, in order to be ‘independent’, a director must not be employed by the company (or have been employed for the past three years), receive more than $120,000 in annual compensation from the company (other than for service on the Board)(or have received such compensation in the last three years), be an immediate family member of a current partner of the company’s outside auditor or someone who served as an executive officer of the company during the prior three years, among other requirements, and subject to certain exceptions from such rules and requirements.

 Independent Committees

Similar to the reasons for having members of the Board who are ‘independent’, and as required by the rules of most exchanges and Nasdaq, the Board should maintain independent committees of its Board to approve compensation, nominations to the Board, and audit/accounting issues. We typically suggest our clients adopt formal charters of a compensation committee (tasked with approving management compensation); audit committee (tasked with approving audit issues and engaging independent auditors); and nominating committee (tasked with approving the nomination of members of the Board of Directors), each of which committee members should be ‘independent’ where possible. It is also important that these committees be provided with sufficient power to approve, without undue influence from the Board of Directors, those matters with which they are tasked in their charters, so they can truly operate independently.

Separate CEO and Chairman

Another way to add an additional check and balance to a company’s corporate governance controls is for the company to require that it maintains a separate Chief Executive Officer and Chairman. By requiring this relationship, the separate Chairman, who will typically be independent, is provided additional authority to challenge the CEO, if needed, on matters involving the Board and/or the officers of the Company. This type of organization also reduces actual and perceived conflicts of interest between management and the Board.

Limit Service on other Boards; Attendance at Meetings of the Board

In order that directors be properly informed and engaged in company matters, it is recommended that Board members be limited to serving on not more than three or four Boards of Directors at any one time and that they be required to attend a certain percentage of a company’s meetings of the Board to maintain their appointment – for example 75% of all meetings. Otherwise, Board members may be too preoccupied with other engagements and/or not be up to date enough on company matters to make informed decisions regarding the operations of the company.

Confidentiality and No-Trade Policy

We recommend that all of our clients work with us to prepare and adopt a formal confidentiality and no-trade policy (if the client is a public company). This policy describes in plain English the confidentiality requirements that all officers and directors are required to adhere to, e.g., not trading securities based on material non-public information or using confidential company information for personal gain, as well as not disclosing confidential or inside information in general. The no-trade policy for public companies establishes certain blackout dates where officers, directors and employees are prohibited from trading in company securities in order to make sure that no one trades any securities based on material non-public information which hasn’t yet been disseminated to the public. Typically, the non-trade policy will prohibit trading in company securities for two business days after the release of material information (in order to allow material non-public information to be fully digested by the marketplace) and for some pre-determined time period prior to the due date of the company’s periodic reports (to avoid anyone who may have access to pre-release financial results from trading on such information, either purposefully or accidently).

We also recommend that officers, directors and employees contact legal counsel if they have any questions regarding the policies or potential violations of such policies.

10b5-1 Plans

One way to avoid or at least significantly limit potential liability for trades based on non-public information is to have officers and directors adopt 105-1 plans. Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, provides an affirmative defense to claims that a person’s trading of securities is ‘on the basis of’ material nonpublic information, if:

“(A) Before becoming aware of the information, the person had:

(1)       Entered into a binding contract to purchase or sell the security [i.e., a 10b5-1 plan],

(2)       Instructed another person to purchase or sell the security for the instructing person’s account, or

(3)       Adopted a written plan for trading securities [which is included in the 10b5-1 plan];

(B)       The contract, instruction, or plan described [above]:

(1)       Specified the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold;

(2)       Included a written formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold; or

(3)       Did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; provided, in addition, that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when doing so; and

(C)       The purchase or sale that occurred was pursuant to the contract, instruction, or plan.”[2]

 As such, corporate insiders are able, under Rule 10b5-1 to enter into a trading plan, providing authority (typically for a broker) to sell their securities based on certain algorithms or formals over time, which, as long as the insiders don’t have any direct control over such sales, serves as an affirmative defense to claims of insider trading.

 In the event any insiders of our public corporate clients desire to sell securities, we always recommend that they enter into a 10b5-1 plan to decrease their exposure and void claims for insider trading.

Whistleblower Policy and Code of Ethics

Every company should adopt, if they haven’t already, a code of ethics which applies to all employees, officers and directors, to promote the honest and ethical conduct of such persons. Additionally, we suggest all of our clients adopt a whistleblower protection policy which provides steps that employees and others can take to report unethical and illegal behavior. It is important that the whistleblower policy include the ability for persons to anonymously report wrongdoing (typically by calling a 1-800 number) and to prohibit any type of retaliation based on reporting.

The ethics and whistleblower policies should also require that issues be reported up the chain of command – i.e., from an employee to an officer, from an officer to an executive officer, and from an executive officer to the Board, while also encouraging outside legal counsel to be alerted to any issues as soon as possible so that counsel can work with the corporation to make sure that proper protocol is followed and that any interested parties who may have a vested interest in the outcome of any investigation be separated from the investigation and that only impartial persons be tasked with dealing with allegations and claims to avoid conflicts of interest and claims of impropriety (even if unfounded).

For example, if a controller becomes aware of potential accounting issues or fraud, such person should immediately bring the issue to the attention of the Chief Financial Officer of the company, and depending on the outcome of that discussion, may also want to bring the issue to the company’s Chairman and/or the Board of Directors as a whole. If warranted, the Board of Directors may want to engage outside independent counsel to investigate the issue and provide an impartial report on the matter. It is important that any issues are addressed promptly to avoid ongoing and/or compounding problems. If the issues are significant, they may require a restatement of prior financial statements, which could lead to liability for the company and its officers.

Stock Ownership

 One way to align the interests of management (officers and directors) with those of the shareholders of the company is to require management to hold a certain percentage of the company’s outstanding securities. This requirement can be set forth in a formal plan which can be prepared by counsel with the assistance of management. When management has a vested interest (i.e., ownership) in the securities of a corporation they have an incentive to (1) remain with the corporation (especially if the interest or some part thereof is subject to forfeiture), and (2) steward the corporation’s growth and compliance, including its corporate governance.

Regular Meeting Dates

The Board, either together with counsel, or separately, should schedule regular meetings of the Board at least quarterly, if not more frequently. The Board should, when possible, attempt to schedule meetings far enough in advance so that all members of the Board can take appropriate action to attend meetings in person if possible, or otherwise via telephone or video conference. As described above, directors and committee members should attend not less than 75% of all Board and committee meetings of the Board’s and committees on which they serve.

Other Proactive Steps Counsel Can Take to Help Corporation’s Maintain Good Controls and Procedures and Corporate Governance

Scheduling Reoccurring Dates and Filings

Some corporate filings and reports are required to be made by the same dates each year. Things like annual lists of officers and directors and franchise tax filings have set annual filing dates (which vary depending on the jurisdiction of formation of the corporation). Counsel should prepare a listing of such dates for the company and the Board and should create reminders of such filing dates (ideally in an electronic calendar program which sends email reminders automatically), so that the corporation doesn’t miss required filing dates. The failure to file annual state reports and pay franchise taxes on a timely basis can result in the corporation being out of good standing and/or in extreme cases, result in the forfeiture of a corporation’s corporate charter.

Similarly, public companies will have certain reoccurring filings due each year – quarterly reports (due once per quarter for three quarters of the year – between 40 and 45 days after the end of each quarter, depending on the company’s market capitalization), annual reports (due after each fiscal year end – between 60 and 90 days after each fiscal year end, depending on the company’s market capitalization), annual stock exchange notices and confirmations and may also be required to hold an annual meeting each year (exchange and Nasdaq listed companies are typically required to comply with this requirement, subject to certain exceptions). It is important for both the company and its legal counsel to maintain a list and checklist of all of those items and filing dates so that nothing is inadvertently missed or filed untimely.

Equally important for public companies is that they advise legal counsel immediately upon entering into any material agreements (or better yet, give legal counsel a heads-up when such agreements are being discussed – if counsel is not involved in the negotiation process). The reason for this is that under Form 8-K, a public company is required to disclose the occurrence of certain material events (entry into material agreements, compensation of officers, changes in officers and directors, acquisitions, dispositions, issuances of securities (subject to certain minimums), changes in auditors, and other matters) with the Securities and Exchange Commission, within four business days of such events. Because that clock starts running immediately upon the occurrence of the event, it is important that legal counsel be advised as soon as possible to begin preparing the required disclosures.

The failure to timely comply with the required Form 8-K filing rules and/or to timely file periodic reports with the Securities and Exchange Commission can result in liability for the public company and its management and result in the issuer not being eligible for Rule 144 (used for the resale of restricted securities) and short-form registration statements on Form S-3 (which can have significant negative effects on an issuer’s ability to raise capital through the public sale of securities), can often result in penalties under lending documents and/or, in extreme situations, the delisting of an issuer’s securities from the NYSE or Nasdaq.

Separate from the obligations of issuers to file reports with the Securities and Exchange Commission, officers, directors and greater than 10% shareholders of public reporting companies are required to disclosure their ownership and changes in their beneficial ownership on Forms 3, 4 and 5. A Form 3 disclosing the initial beneficial ownership of all covered persons is required to be filed by a covered person within 10 days of the person becoming a covered person (i.e., becoming an officer, director or greater than 10% shareholder) and Form 4s are required to be filed disclosing all changes in beneficial ownership of covered persons, subject to certain exceptions within two business days of each transaction. Form 5s are required to be filed on an annual basis to disclose any transactions not previously disclosed on a Form 4. The failure to make required Form 3, 4 and 5 filings is disclosable by the issuer in its annual report and/or proxy statements, and can result in liability for the covered person with the Securities and Exchange Commission.

Similarly, all greater than 5% shareholders are required to file ownership disclosures with the Securities and Exchange Commission on Schedule 13D or 13G (Schedule 13G (a shorter filing that Schedule 13D), if the Schedule reports beneficial ownership of between 5-20% of the issuer’s outstanding securities and the holder is a passive investor has no intention of influencing control over the issuer – i.e., at a minimum, the Schedule 13G cannot be filed by officers or directors of the issuer). Schedule 13D/Gs are required to be filed within 10 days of the event which results in such person becoming subject to the filing obligations and amendments thereto are required to be filed promptly upon any material change in the ownership percentage of securities disclosed therein (deemed to be a change of 1% or more from the original amount disclosed) and within forty-five days after the end of each calendar year, if, as of the end of the calendar year, there are any changes in the information reported in the previous filing on the initial Schedule.

Officers and directors should be advised to promptly update the issuer’s counsel on all changes in beneficial ownership so that the proper ownership forms can be prepared and filed to avoid liability and prevent any negative optics which may result in late filings.

 Instructions and Stops with Transfer Agent

Many transfer agents (stock registrars) we and our clients deal with will allow the issuance of securities upon the conversion of convertible securities presented from third parties and the unlegending of securities presented for resale without requiring any sort of approval by the issuer. We advise all our clients to immediately place their transfer agents on notice to not process any issuances or transfers without pre-approval by the issuer. This allows the issuer the opportunity to review proposed issuances and transactions to ensure both that any convertible securities presented for conversion and issuance are valid and held by the correct holders, but also that any legal opinions presented for restrictive legend removal and/or resale are valid. Typically, if issues are determined to exist in connection with any securities presented for transfer to an issuer’s transfer agent (including any legend removal), the issuer is required to obtain a court order to stop its transfer agent from being required to process the transfer under applicable rules. As such, it is important that as much time as possible be provided for an issuer to review all third-party issuances/transfers.

Corporate Counsel’s Disclosure of Material Laws and Regulations

Shortly after being engaged as counsel, once every couple of years for continuing serving management and earlier with new members of management, legal counsel should schedule a meeting or conference call with management to discuss material rules and regulations which management should be aware of. While many of those regulations will vary by industry, all management and employees should be made aware of the requirements of the Foreign Corrupt Practices Act (FCPA) and public company officers and directors should be made aware of potential issues with short-swing profits (discussed below).

Foreign Corrupt Practices Act (FCPA)

The FCPA makes it illegal for companies and their personnel to make payments to foreign government officials for the purpose of assisting in obtaining or retaining business. “Specifically, the anti-bribery provisions of the FCPA prohibit the willful use of the mails or any means of instrumentality of interstate commerce corruptly in furtherance of any offer, payment, promise to pay, or authorization of the payment of money or anything of value to any person, while knowing that all or a portion of such money or thing of value will be offered, given or promised, directly or indirectly, to a foreign official to influence the foreign official in his or her official capacity, induce the foreign official to do or omit to do an act in violation of his or her lawful duty, or to secure any improper advantage in order to assist in obtaining or retaining business for or with, or directing business to, any person.”[3] In order to avoid liability under the FCPA, it is important that all employees be made aware of the rule and reminded of such rule on a regular basis. Similarly, the whistleblower policy discussed above should provide for anonymous and non-retaliatory reporting of violations of the FCPA.

Short Swing Profits

Section 16(b) of the Securities Exchange Act of 1934, as amended, provides that profits obtained by an officer, director or greater than 10% shareholder, from the sale of a security purchased in the prior six months, are recoverable by the issuer, irrespective of the intention of the covered person, subject to certain exceptions. The way rule works is to match all purchases and sales in the applicable six-month period to maximize ‘profit’, even if the sale occurred prior to the purchase. For example, if an officer sells 100 shares for $500 on January 1st of an applicable year and purchases 100 shares for $75 on May 31st of the applicable year, the insider will be deemed to have ‘profited’ by $2,500 (($100-$75) = $25 x 100), even though the sale occurred prior to the purchase. The right to recover the ‘profit’ is automatic and the intent of the covered person has no bearing on the right. As such, if a covered person is ignorant of the rule or fails to consider ‘short swing’ profits when they buy and sell securities, the rule applies automatically. Even unwinding the offending transaction typically has no effect on the liability.

Because officers, directors and greater than 10% shareholders of public companies are required to disclose changes in beneficial ownership on Forms 4 and 5 (as discussed above), the covered persons themselves are the ones who are often tipping off the marketplace to their own Section 16(b) liability.

Shareholders who bring suits to enforce Section 16(b) liability (shareholders can personally bring suit on behalf of the issuer if they provide notice of the claims and the issuer fails to recover the ‘profit’ in sixty days) are also able to recover attorneys’ fees. As such, there is an incentive for law firms to file short-swing profit lawsuits and covered persons quite often inadvertently cause themselves significant liability for undertaking matching transactions. To avoid potential short-swing profit issues we suggest that all officers and directors run all transactions occurring within six months of each other (or better yet, all transactions whatsoever) by outside legal counsel so that counsel can confirm no short-swing profit issues are triggered by the proposed transaction.

Counsel’s Review of Press Releases, Websites and Other Public Correspondence

We have found that regulators often use an issuer’s press releases, the disclosure on its websites and other public correspondence when they bring claims for misleading statements and violations of the securities laws. In an effort to avoid these issues – some of which can just be chalked up to overzealous drafters who don’t have knowledge of the securities laws and the issues which can be caused by hyperbole – we recommend that all of our clients provide us an opportunity to review press releases, website disclosure and other public correspondence before such information is publicly disseminated. More often than not, having a fresh set of legal eyes look over planned disclosures can avoid potential issues down the road. Sometimes edits are as simple as using forward-looking language (may, believe and hope), which is protected by the securities laws and related safe harbors, rather than more definitive language which we find our clients are fond of (such as will, has and when), which in turn can create more liability from regulators and shareholders when the projections and future events disclosed don’t, for whatever reason, come to fruition.

Clawback Policy

Although it was originally required to be implemented by The Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank), no formal claw back rules are currently in effect under Dodd-Frank. Notwithstanding that, we suggest that companies adopt clawback policies for good corporate governance. In effect a clawback policy generally requires executive officers to repay or forfeit any annual incentive or other performance-based compensation awards they previously received, if the payment, grant or vesting of the awards was based on the achievement of financial results that were subsequently the subject of a restatement of the company’s financial statements filed with the Securities and Exchange Commission, the Board of the company determines in good faith, that the executive officer engaged in fraud or misconduct that caused or contributed to the need for the restatement, the amount of the compensation that would have been received by the executive officer had the financial results been properly reported would have been lower than the amount actually received, and the Board determines that it is in the best interests of the company and its shareholders for the executive officer to repay or forfeit all or any portion of the awards. Having a clawback policy in place makes clawback easy to implement and typically takes away one of the claims which shareholders bring against issuers and management when a restatement applies – i.e., that the officers overstated results in an effort to trigger incentive compensation tied to the issuer’s operating results.

Annual Review of Corporate Governance

It is a good idea for companies to meet at least once a year with counsel to discuss any issues or concerns which occurred during the prior year in connection with the company’s corporate governance. At these meetings officers can detail any breakdowns in corporate governance which occurred during the prior year and the entire team (officers and counsel) can work on putting in place procedures, checks and balances, so that similar issues can be avoided moving forward and new proactive procedures can be implemented.

Succession Plan for Management

A Board of Directors and where applicable, the nominating and corporate governance committee, should keep an informal running list of potential candidates to fill the positions of principal executive and financial officers (CEO, CFO, COO, etc.). The reason for this is that if something should happen to current principal executive or financial officers, their untimely death, resignation or removal, it may be necessary and warranted to find a replacement, even if only on an interim basis, as soon as possible and if the Board of Directors/committee already has a list of potential candidates it can make the process of filling vacancies much faster.

Responsibilities of the Board of Directors

Below is a summary of the responsibilities of the Board of Directors as it relates to Corporate Governance.


The Board of Directors (Board) of a corporation has the right, but not the obligation, to appoint one of its members as the “Chairman” of the Board. The Chairman is typically responsible for presiding over meetings of the Board, and being the main point of contact with management (officers) of the Company. The Chairman has significant authority of the matters discussed at meetings of the Board.

Board Members

The members of a corporation’s Board of Directors are typically appointed by the common shareholders of the corporation. Typically, if the corporation does not have a classified Board of Directors, director’s appointments are on a year-to-year basis and Directors are up for re-election each year at the corporation’s annual meeting of shareholders. Directors are most often appointed by plurality vote or majority vote of shareholders.

The Board’s duty is to represent the shareholders of the corporation and oversee the management of the corporation – generally voting internally on whether or not to approve material transactions involving the corporation and those proposals on which the approval of the shareholders should be sought. For example, amendments to the articles of incorporation or a re-domicile to another jurisdiction, which require the approval of shareholders under state law.

Public companies whose securities are traded on the NYSE or Nasdaq are required to have, and all companies are recommended to have, ‘independent’ members of the Board (as discussed previously).

In order to best represent the shareholders, the Board typically meets several times per year to discuss the direction of the company, results of operations, and the company’s plan of operations. Additionally, at least one per year, if not more, the independent members of the Board should meet without management present to discuss, confidentially, the status of the officers of the company (CEO, CFO, COO, etc.) and their progress towards meeting the company’s short and long-term goals.

The Board is generally responsible for establishing policies and objectives for the company; making the final decision on the hiring and employment terms of high level executives (such as the CEO and CFO), and reviewing the performance once hired, of such executives; reviewing and approving annual budgets; approving material transactions and agreements (typically those agreements entered into outside of the usual course of business, including the sale and acquisition of material assets or operations, and material supply/sale agreements); approving the issuance of the company’s securities and where applicable the repurchase of such securities (i.e., stock buyback plans); and shaping the company’s business plan and plan of operations.

Because the Board is appointed by the shareholders, the Board is responsible to undertake actions that are in the best interests of the shareholders, and where possible, to maximize the long-term value of the company’s equity interests.


The Board appoints executive officers, who are entrusted with the power to carry on the corporation’s business, pursuant to the guidelines and plan of operations set, from time to time, by the Board; however, such officers are only agents for the Board.

Fiduciary Duties of the Board of Directors

Pursuant to state law, the Board is generally vested with the power to exercise all of the rights and powers of the corporation, subject to certain limitations set out by statute or established by common law, i.e., the Board’s fiduciary duties, including the duty of care, duty of loyalty, duty of good faith and a duty to avoid conflicts of interest.

Duty of Care

The duty of care has to do with information and review of such information. Specifically, each member of the Board is required to adequately review information his or her self about each matter which comes before the Board for approval. Each member of the Board is also tasked with understanding the information presented, ensuring that they have reviewed all material available at the time of making a decision and assessing the information in order to make informed decisions.

While the ‘business judgment’ rule (the common law presumption that, absent self-dealing or other interested party issues, the Board has exercised reasonable business judgment in all decisions), generally protects members of the Board for their actions and insulates them from liability, even for actions which produce negative results, if a Board is found to have breached their fiduciary duties, courts may not apply the ‘business judgment’ rule. Additionally, in certain transactions (including when related party issues are present), the Board’s actions may not fall under the ‘business judgment’ rule, but instead the Board may be required to maximize the value of the transaction for the shareholders of the company (which requires a more detailed analysis of potential transactions and different standard for approval than other transactions).

Part of the duty of care involves evaluating the current transaction presented to the Board versus possible alternatives, and whether more favorable terms can be obtained from third parties or from further negotiation of proposed transactions.

Duty of Loyalty

Similar to the duty of care, the Board owes their shareholders a duty of loyalty. The duty of loyalty requires members of the Board to act in good faith and not allow personal interests (or interests of majority shareholders or third parties) to override the interests of the corporation and its stockholders. The duty of loyalty is most often an issue when Board members have conflicts of interest between their own personal interests (i.e., where a Board member may benefit personally from a transaction) and those of the shareholders. Oftentimes members of the Board will be asked to, or should voluntarily, abstain from voting on matters in which they have a personal interest or which could result in them obtaining a greater benefit from other shareholders.

For example, in the situation of an executive-director of a corporation who has a change of control provision (or golden parachute provision) in his or her employment agreement which would be triggered by a business combination which has been proposed for approval to the Board. Because the executive-director’s interests in the transaction may be different than the other shareholders of the corporation, the executive-director should abstain from voting on such transaction.

Separately, the fiduciary duties of the Board require Board members to make interested party transactions and benefits known to the other members of the Board. The corporate laws of many states provide that transactions approved by the Board without the knowledge of related/interested party conflicts between Board members may be voidable.

Directors should also consider their duty of loyalty when responding to takeover bids and tender offers. The implementation of certain defensive tactics or other efforts that may have the effect of protecting management (i.e., protecting the employment of management), while ultimately being detrimental to shareholders (who may otherwise receive a premium to market for their securities) may be deemed a breach of a member of the Board’s duty of loyalty. When in doubt, it is sometimes better for the Board to allow shareholders to vote on material transactions (i.e., acquisitions and mergers with consideration payable above the current market place of the company’s securities), instead of rejecting such transactions outright, to avoid potential breaches of the duty of loyalty and allow the shareholders, who are the ultimate decision makers of a corporation, to determine themselves whether or not they believe such transaction is fair.

Duty of Good Faith

The duty of good faith encompasses many of the duties required by the duty of care and loyalty and generally requires members of the Board to act in good faith and to not violate law in connection with corporate decisions.

Conflicts of Interest

Separate from the above, members of the Board should seek to avoid ‘conflicts of interest’ (i.e., a transaction which creates a conflict between the benefits received by the director (or his or her affiliate, immediate family member or related party) on one hand and the corporation or shareholders on the other hand). As described above, when a ‘conflict of interest’ presents itself the Board member should make such ‘conflict of interest’ clearly known in detail to the Board and abstain from voting on the transaction which creates/could create a ‘conflict of interest’. It may also be necessary to establish a related party transaction committee (or task the audit committee with approving related party transactions) to further insulate the Board of Directors from potential related party conflicts.

Confidential Information

Directors should treat all material non-public information regarding the corporation as confidential and not use such information, directly or indirectly, for any purpose, other than in connection with their service to the corporation as a member of the Board. Directors should not trade securities (whether of the corporation or other company’s) or advise anyone to trade such securities, based on material non-public information which they learn about through their service as a member of the Board. As discussed previously, companies should work with their counsel to prepare and adopt a formal confidentiality and trading plan to memorialize formal procedures and requirements relating to the above.

[1] ICSA: The Governance Institute (

[2] See Rule 10b5-1(c) (