Board Of Directors

Quick Summary of Board Of Directors

The directors are a company’s most senior managers and are elected to run the company by shareholders. Directors of public companies generally have to be re-elected by shareholders every 3 years which is usually just a formality, but there are occasional upsets.

In relation to a company or other formal organization, a director is an officer (that is, someone who works for the company) charged with the conduct and management of its affairs. A director may be an inside director (a director who is also an officer or promoter or both) or an outside, or independent, director. The directors collectively are referred to as a board of directors. Sometimes the board will appoint one of its members to be the chair or chairperson of the board of directors, traditionally also called chairman or chairwoman.

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 (such as a finance director or a marketing director) who deal with particular areas of the company’s affairs.

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) granting proxies to the board to vote their shares at general meetings and the large numbers of shareholders involved, the board can comprise a voting bloc that is difficult to overcome. However, there have been moves recently to try to increase shareholder activism amongst both institutional investors and individuals with small shareholdings. A board-only organization is one whose board is self-appointed, rather than being accountable to a base of members through elections; or in which the powers of the membership are extremely limited.

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.

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 they were (often because they wrongly believe that they have 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 themselves 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 (of all shareholders) 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.

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 meaning 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.”

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 or 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.

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; the company must often supply a copy of the proposal to the director, who is usually entitled to be heard by the meeting. The director may require the company to circulate any representations that he wishes to make. 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.

In most common law countries, the powers of the board are vested in the board as a whole, and not in the individual directors. 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. This doesn’t mean that directors can never stand in a fiduciary relationship to the individual shareholders; they may well have such a duty in certain circumstances.

Acting In Bona Fide

Directors must act honestly and in bona fide. The test is a subjective one—the directors must act in “good faith in what they consider—not what the court may consider—is in the interests of the company…” 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.

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, 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. While 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, while 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. 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.

“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. 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.

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 than 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, 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, 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.

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 a dual subjective and 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 and subjectively; in the United Kingdom, the statutory provisions relating to directors’ duties in the new Companies Act 2006 have been codified on this basis. More recently, it has been suggested that both the tests of skill and diligence should be assessed objectively and subjectively and in the United Kingdom, the statutory provisions in the new Companies Act 2006 reflect this.

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, directors’ 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. Previously in the United Kingdom, 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.

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 oversees 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 for U.S. companies or companies listed on U.S. stock exchanges. Under the Act, members of the board 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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