Introduction to Directors and Officers

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Terms:


Corporate Governance
Corporate governance is the general term used to describe the management of a company and the behavior of its managers. In the post-Internet-bubble era, a great deal of reform of corporate management has taken place in an attempt to improve corporate governance.

Fiduciary and Fiduciary Duty
A fiduciary is a person who owes certain obligations to another person or entity. A fiduciary duty is any one of those obligations. As an example, consider a person who is entrusted with administering a trust. The administrator, who is called a trustee, is a fiduciary of the trust, and is obligated to act in accordance with the terms of the trust while complying with all laws regarding handling the trust, in order to preserve the funds in the trust. These obligations are the trustee's fiduciary duties. In the context of a corporation, the managers and directors of the firm are said to be fiduciaries, owing various duties (including care and loyalty) to the corporation and its shareholders.

Chief Executive Officer (CEO)
The CEO of a company is the employee in charge of the firm. The CEO (sometimes called the president or executive director) has ultimate responsibility for the daily operations of the company.

Chief Financial Officer (CFO)
The CFO of a firm is the employee tasked with managing the company's finances. Often a CPA or other financial expert, the CFO has ultimate responsibility for the company's accounting, tax and reporting obligations. The CFO is also in charge of oversight of the company's financial health.

Chief Operating Officer (COO)
Known by any one of a variety of names, depending on the company, the COO can be identified as the individual employee tasked with oversight of the company's business operations.

Accounting Standards
The Generally Accepted Accounting Principles (GAAP) are a set of rules created by the Financial Accounting Standards Board (FASB) to guide companies in how they should account for various transactions and create their financial statements.

General Counsel
A company’s general counsel is, typically, the highest ranking attorney working for the company. Generally, this lawyer will be employed by the company itself (not a law firm) and will act as one of the company’s executives. GCs can be found mainly in larger companies.

Introduction

Once a firm has been formed, unless it has chosen a business form where corporate governance is reserved for the company's owners (i.e., a professional company or sole proprietorship), the company needs to identify the individuals who are going to run it. Generally, when we refer to the people who run a company, the reference is to the company's directors and officers. Technically, the idea of directors and officers applies only to the corporate form, as it is only the corporate form that mandates the bifurcation of the governance function in this way. In general, a business of another form may choose to elect a subsection of its owners to manage the firm. In a general partnership, a managing partner committee might be formed. In a limited liability partnership, the general partner will act in largely the same way as a combined officer/director group. Similarly, an LLC might identify a special subcommittee of its members to manage and operate the firm.

In any of the above cases, those individuals specifically tasked with the "big picture" management of the company are the individuals with whom this chapter is concerned. In this chapter, we will speak generally about directors and officers as they exist in the corporation. What is important to keep in mind is that the heightened standards discussed in this section are, generally, also applicable to any "management committee" found in any other business form.

The Board and its Directors

So far, we have occasionally referred to "the board of directors," "the board" or "the directors" of a company.

In the business world, a company's board is the group of individuals (known as directors) who are tasked with the ultimate management of the firm. A company's board, which will typically consist of anywhere between three and fifteen people, is the final source of decision making for the company. Thus, the individuals on the board will typically come from a variety of backgrounds, which relate directly to the various functions of the company.

The typical corporate board for a midsized company might include the following people:

  • The company's president or chief executive officer (CEO) and, perhaps, one or two other major company employees like the chief financial officer (CFO) or chief operating officer (COO)
  • An individual who is an expert in financial matters (maybe the CFO) and accounting standards (probably a CPA)
  • The company's highest ranking attorney - usually referred to as the general counsel
  • One or more individuals who are experts in the type of business conducted by the company (for example, a company doing genetics research might have a well-known geneticist or researcher on its board)
  • One or more of the company's most important investors (typically, this might be a venture capitalist if the company is still in its start-up stage, or a major shareholder if the company is public)
  • Other board members might include a celebrity (to gain recognition) a current or former government official (to gain political favor) and perhaps a well-known business professional.

Typically, a board will consist of an odd number of individuals so that there will be a majority in close votes.

EXAMPLE:  (CEO) and Lance (CFO) have recently formed a new firm. They manufacture military equipment, and they expect that their single largest customer will be the U.S. government. As such, when they go about forming their board, they choose to include themselves, their general counsel, three key investors and a retired   U.S. Army general.

Inside / Outside

In constructing its board, the company needs to be aware of the many individuals and entities that will have concerns about the firm, including investors, shareholders, employees and the business community in general. It should try to find directors who can represent these concerns on the board. Additionally, modern companies are well advised to address a concern that was raised as a result of corporate governance scandals in the post-Internet-boom days, by forming a board that has a majority of outside, as opposed to inside, directors.

The inside/outside dichotomy is as simple as it sounds. Inside directors are those who have a direct personal or financial stake in the company. They may be employed by the company or have a large investment in the firm that they want to protect. Outside directors are individuals that have no direct financial or professional stake in the firm. Rather, they are willing to act on the company's board either in return for some compensation from the firm (which is generally nominal) or simply in order to help the firm succeed, thereby improving their own business reputations.

A company might choose to have a majority of its board consist of outside directors because such directors are assumed by the business community to be able to offer the company better, or at least more impartial, advice. In short, they are viewed as having an unbiased view of the firm and are likely to make those decisions and recommendations that are for the benefit of the firm and its shareholders rather than their own jobs or pocketbooks. For publicly traded companies, belief in the virtues of appointing outside directors has grown to the point that the major securities markets, NYSE, AMEX, and the NASDAQ, have all come to require that a majority of directors be from outside the firm.

EXAMPLE: Tech Edge is a company that has been in business for the last seven years. It is contemplating an initial public offering (IPO) some time in the next few years. As such, it has decided to expand its board to make room for several new board members who are unaffiliated with the company, so that of the board’s nine members, at least five – a majority – will be outside directors.

Chairman of the Board and Subcommittees

The person in charge of the board is known as the “chairman” of the board.

Additionally, boards may, of their own volition, create subcommittees to advise the full board on certain aspects of the company's operation. Typically, a board will have a subcommittee on finance and/or accounting that will oversee the financial health of the firm and its tax and accounting issues. The firm might also have a special legal committee or litigation committee if the firm is facing, or often engages in, legal matters or litigation. The company may also have an election committee to oversee the annual board elections.

There is generally no limit on the types or number of subcommittees that a board may create. It is important to recognize, however, that in virtually all states, the committees may not, themselves, take actions on behalf of the company or its shareholders. Rather, the subcommittee will simply recommend actions to the board, who, in turn, will make recommendations to the shareholders. See Cal Corp Code § 300.

EXAMPLE: Pyro Co. was facing a lawsuit for a recent explosion that occurred at one of its fireworks factories. Given the situation, the company’s board decided to form a special litigation committee to make recommendations to the board on various issues, such as settlement and strategy, during the litigation.

Operation of the Board

The job of the board is to oversee the "big-picture" operation of the firm. Tasks that are wholly within the control of the board include the following:

  • Declaration of dividends
  • Calling special meetings
  • Creating board committees
  • Hiring and firing executive officers
  • Making recommendations to shareholders

Officers

Officers are those employees of a company who are tasked with actually managing the daily business of the firm. The group of officers typically includes the CEO, CFO, COO, general counsel, and various other individuals in charge of specific business units or internal management of the firm. It is sometimes difficult to tell based on an employee's job description whether or not she is an officer without knowing her title. Characteristics that indicate that an individual is an officer of the company, rather than a senior employee, include some of the following:

  • Contracting Authority – Typically, an officer will be empowered to make contracts that bind the company as a whole or a significant part of the company.
  • Speaking Authority – Officers will often have the ability to speak “on behalf of” the company. Their statements bind the company and will have ramifications, potentially in contract and tort, for the company as a whole
  • Obligations to Report – Company officers will also have a heightened obligation to report on the condition of the company. This will include reports on the financial health and business prospects of the company.

See Cal Corp Code § 312.

While it may be difficult to distinguish between officers and senior employees, it is frequently a critical distinction. Typically, the difference lies in the extent of the individual’s power to effect change or bind a large portion of the firm. Additionally, it is these individuals that the firm will seek to insure and, as we will see below, to indemnify in the event that any actions by that person may injure the firm.

EXAMPLE: A contract was signed by an employee of Standard Co. that was supposedly on behalf of the entire firm. However, when the supplier attempted to enforce the contract, Standard refused payment, stating that the employee who had signed the contract was not an officer of the firm, and was not acting within his job description. When the issue finally reached the courts, the judge’s decision rested on whether or not the employee was in fact an officer of the firm. In reaching her determination, the judge looked at the employee’s speaking authority, contracting authority, and reporting and management obligations to the firm.

Thus, a corporation can actually turn out to be liable for a contract entered into without its authority if the officer who entered into the contract generally has the authority to speak and/or negotiate for the corporation. See In re Drive-In Development Corp., 371 F.2d 215 (7th Cir. 1966).



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