SELECTING THE BOARD OF DIRECTORS-DOING IT RIGHT
During the often exciting time of creating a new corporation and executing the various paperwork, few future owners of a corporation take the time to consider what are the appropriate decisions as to who to place on the Board of Directors, the main governing body of a private corporation. The new owners typically concentrate on the identity of the officers (President, CEO, Treasurer, etc.) and the respective share ownership of the founders (who is the majority owner, who is the minority, etc.) and create the board almost as an afterthought.
Their reasoning is the correct assumption that, ultimately, the majority shareholder or interest holder can control the entity by voting the interest or stock. What they fail to understand is that in order for the majority shareholders to vote out a hostile board, it may take anywhere up to a year and during that time period the board of directors continues in effective control of the company. The Board can normally remove officers, alter goals and business plans of the company, allocate income and do so with near impunity.
Most companies start out with good will and cooperation of all the participants. That does not always last and struggles between shareholders, officers and the board of directors is not uncommon.
This article shall describe the powers of the board, the timespan needed to change the board, and how the owner of the company can better protect the owner and the officers from a hostile board of directors. It will also discuss how to choose a board that will help and not interfere with the operations of the company.
The Basic Structure: the Role of the Board of Directors:
As discussed elsewhere on this website, a non public corporation is akin to a small republic. The shareholders, usually by majority vote, elect the board of directors and that board appoints the officers. The officers usually serve at the pleasure of the board and the board is elected usually once a year. Normally, the person who owns 51% of the outstanding stock can elect a majority of the board of directors and by controlling the board, can control who is selected as the officers of the company. Thus, ultimately, the majority shareholder has effective long term control of the company since the majority owner appoints the majority of the board which selects the officers.
In general terms, the board of directors makes strategic decisions while the officers run the day to day operations of the company. The President (sometimes called the Chief Executive Officer) has operational control of the day to day actions of the company but the Board can normally remove the officer either with or without cause.
The officers and the directors have a fiduciary duty to the company. They must act without conflict of interest and in what they perceive to be the best interests of the company. Shareholders normally do not have such a fiduciary duty. And, of course, shareholders can act as members of the board and as officers, but need not.
In terms of numbers of directors who must be elected, for directors the number is not less than three, unless there are only one or two shareholders of record, in which case the number of directors may be less than three but not less than the number of shareholders.
In terms of officers, the three required positions are President, Secretary and Treasurer. Although most jurisdictions allow one person to serve in all three capacities, that person has different responsibilities depending on the capacity in which he or she is acting.
Directors can normally call special meetings with ten days’ notice and must meet at least once a year. Shareholders normally meet once a year to elect directors and receive reports from the directors.
The board has a duty not only to supervise the actions of the officers to the benefit of the company, but to generally supervise the activities of the company and make strategic decisions for the company.
The Problem- Timing:
It takes a long time to remove a director for a good deal of the year. Anywhere between eleven months and a day or two…but taking a chance that the timing will work for you is risky.
Assume that your directors serve an annual term and you are two months into their term. Until their annual election, you, as majority shareholder, can only remove them “for cause,” but “cause” under California law has to be clear breach of their duty to the corporation, NOT just a difference of opinion with you.
Assume a board of five directors and three of them disagree with you as to payment of a large salary to a new salesperson you think is vital to the future of the company. They refuse to allow it and threaten to fire you as CEO if you are foolish enough to ignore their instruction. You indicate that this person will be grabbed by a competitor if you do not hire him now and the future of the company demands it. The board disagrees.
They win. If you make an offer to hire him, they will fire you as CEO and vote to rescind your offer. They disagree with you but since they are seeking the best interest of the company, if you try to remove them for cause they can fight it, use corporate funds to defend themselves in court, and you are likely to lose. Meanwhile, since the possible employee is now hired by a competitor, the matter is moot…the court will state that there is no realistic relief available. Ten months later you can remove them…and rehire yourself as CEO once you elect a board that agrees with you. But meanwhile, you company may very well falter or fail and your salary has stopped.
It is vital to understand that the board may be composed of sincere people who truly think they are doing the right thing. Often they are experienced business people you chose because you respected them. But once they are directors, they are no longer friends or colleagues: they are persons with corporate power and unless you wish to cede that power to them, you have to take appropriate steps to protect yourself even if you initially chose the board and even if you own a majority of the stock.
California law is clear that the director is not occupying a passive position. The director is under a duty to actively involve him or herself with corporate matters and even has a duty of reasonable inquiry if he or she feels that something requires more investigation or study. The law does not allow them to sit back and come in once a year to rubber stamp the actions of the CEO: they are required to actively and intelligently supervise and, in some cases, approve his or her actions, depending on the By Law requirements.
The duty is imposed upon them and if they fail to exercise it, they can be personally liable for breach of duty to the company. They cannot just passively agree to support anything the CEO wishes: they are required to form their own conclusions and investigate the facts if necessary. And vote against the CEO if their sincere opinion requires it.
And if there is a fight as to control between the board and the CEO, and if they are a majority of the board, they can require the company, itself, to pay any legal costs they incur in the court case. The CEO is thus not only stymied, but, if fired, cannot have the company pay his or her legal costs while the board of directors can and meanwhile the CEO’s salary has been stopped.
Proving “for cause” removal is very difficult. Most judges do not want to put their own opinions above that of the board. Usually the court will simply state that the majority shareholder should wait for the next election and remove the directors at that time.
The Problem- It Can’t Happen Here:
It is thus clear that the careful selection of membership of the Board is a vital decision for the shareholders of the company. However, when forming the company, most owners assume that the expressions of good will at the beginning of the relationship are somehow “permanent” and that the colleagues or friends elected to the board will remain compliant with the plans of the CEO and shareholders. That is usually true. It is not always true.
The fact is that infighting between the officers and others in the company is not that remarkable and can stem from honestly held differences of opinion. Too often the founders will put family members or even employees on the board, assuming that the board which meets once a year will not be a stumbling block to any actions of the officers.
But the board can call meetings as often as it deems it appropriate and most By Laws allow calling of a meeting of the board by any director with ten or fifteen days’ notice. They can meet every week if they wish.
Part of being successful in business is a hard nosed realistic appraisal of risks. Such an appraisal requires which are risks that cannot be avoided and those which are not risks if properly prepared for ahead of time. Selection of the board can be the latter if one can overcome the automatic response that you chose the board so they will do what you want. Perhaps. Perhaps not.
There are numerous ways to minimize the danger of a hostile board.
- Selection Process: Talk to the board about your plans and your need for freedom of action. Gauge their reaction carefully and make sure that you do not have a hidden danger in a board member who will want to supervise day to day operations more than you like. Do not pick family members unless you want to risk family relationships as well. The more business experience a board member has, the more likely she or he will be to allow you freedom to make your own business decisions.
- By Laws: One can put in various safeguards in the bylaws. One can shorten the board tenure to six months if one is willing to go to the trouble of having a six month selection process occur. One can insert various provisions seeking to limit the boards’ powers but those are subject to scrutiny by the courts and are unlikely to be enforced if the board claims their fiduciary duty demands certain actions.
- Employment Agreements: By far the best protection is an employment agreement in which the CEO cannot be terminated except for cause, which is enumerated clearly and objectively. The duties and rights of the CEO are clearly spelled out, including areas in which the CEO has primary responsibility and not subject to overruling by the board, e.g. day to day operations. Make sure the length of the employment agreement is longer than the term of the board.
- Communication: Most boards do not want to involve themselves closely in the activities of the company and are “aroused” when a relatively hostile board member contacts them and seeks to create a problem, either sincerely or not. The way to avoid this danger is keep the board fully advised as to activities of the company and be available to answer any questions that may arise. Reassure the board and ask their advice. And if a board member is actively hostile, communicate to him or her that you need to work as a team, you are willing to work with him or her until they are voted out, but that you need them to be open and businesslike as well. If they refuse…well, you replace at the next shareholders’ meeting and, meanwhile, with an employment agreement, cannot be fired and you lobby the rest of the board…and curse yourself for putting the wrong person on the board.
- Rethink Your Own Position: A board so upset at your actions that they are becoming a counterforce probably sees something that would cause concern to most people. Listen to them. Engage in a deep discussion as to what concerns they have and how you can address them. Negotiate, be reasonable, do not let ego of “I am the CEO” get in the way of working with this board to resolve disputes…and, remember, you can eventually vote them out of office if necessary.
Creating the correct structure with the right protections is akin to buying insurance. No one wants to do it, it takes time and money, and may never be required. But, as with insurance, if you want to maximize your chances for success, you should take the time to do it right, install the right safeguards…and then not worry about what happens if your board