A Few Words About Officers And Directors
Being an officer or director of a publicly traded company can be a lucrative and prestigious position but also comes with fiduciary and statutory obligations. Today’s business environment is built on transparency and the fulfillment of internal controls over financial reporting and disclosure controls and procedures.
In addition to state corporate law obligations, officers and directors are personally subject to specific reporting obligations under the Securities Exchange Act and both reporting and fiduciary obligations under the Sarbanes-Oxley Act of 2002 and Frank Dodd Act of 2010. These measures require that officers and directors of publicly traded companies perform their duties under the scrutiny of shareholders and regulators and adhere to a myriad of complex regulations, primarily based on internal processes and procedures and external disclosure.
Although some directors and officers make decisions that are simply egregious, others find themselves under the gun through no fault of their own for activities that were out of their control or for pursuits they never knew were illegal. These individuals often fail to realize that the key responsibility of a company’s corporate counsel is to protect the company, not them as individuals. It is up to corporate officers to protect themselves in the event they are helping a company with an extraordinary transaction, such as a merger, need to navigate a whistleblower complaint or simply have questions about their duties and responsibilities.
Duties And Legal Responsibilities Of Directors
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship with the corporation and its stockholders, which requires that they act in the best interest of the corporation and its stockholders, as opposed to their own. Key executive officers have a similar duty.
Generally, a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching their decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).
However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash, job security or, as in the case here, a large upside to the transaction closing), the board of directors and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule.”
A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders, such as where directors are on both sides of the transaction or as in this case, where they will benefit from the transaction and lose economics without the transaction. Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings, and price and terms. The entire fairness standard is a difficult bar to reach and generally results in a finding in favor of complaining shareholders.
In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith, as well as the duty of care, the duty of loyalty and the duty of disclosure.
The Duty Of Care
The duty of care requires directors to be informed, prior to making a business decision, of all material information reasonably available to them in the exercise of their management of the affairs of a corporation. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use to further the best interest of the corporation and to exercise good faith under the facts and circumstances.
The Duty Of Loyalty
The duty of loyalty also protects the corporation and its shareholders and requires directors to act in good faith and in the best interests of the corporation and its shareholders. The prevalent legal standard is that the duty of loyalty requires that the director be disinterested, such that he or she “neither appears on both sides of a transaction nor expects to derive any personal financial benefit from it” and his or her decision must be “based on the corporate merits of the subject before the board rather than extraneous considerations or influences.”
The Duty Of Disclosure
The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation and its stockholders.
The Business Judgment Rule
The business judgment rule is a judicial presumption that protects directors from liability for actions taken by them if they act on an informed basis in good faith and in a manner they reasonably believe to be in the best interests of the corporation’s shareholders. The business judgment rule will not apply in cases of fraud, bad faith or self-dealing or in cases of an extraordinary transaction, such as a material merger. In such a case, the court will require the director to establish the intrinsic value and fairness of the transaction.
A director’s duty can be shifted in times of takeover attempts and/or mergers and acquisitions. When an offer has been made to take over a company, the board of directors must:
- Determine whether the offer poses a threat to the corporate enterprise.
- If the offer does pose a threat, the board may only take such action to protect the company as is in proportion to the threat posed.
In their course of maintaining control of the company, directors must be very careful not to place their own self-interest above their duty to the stockholders. A diligent board should have a takeover readiness plan and project team in place prior to the point when a crisis situation occurs.
The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings, the number and frequency of meetings, knowledge of the subject matter, time spent deliberating, advice and counsel sought by third-party experts, third-party valuation and fairness opinions, requests for information from management and requests for reviewing the documents and contracts.
Lawyers, compensation consultants, auditors, underwriters and other outside experts are indispensable components of sound corporate governance. It is important to the independence of directors and committees that they, and not management, choose the advisors who will guide them. Moreover, in crisis management and control situations, outside counsel should be retained immediately. Not only will this preserve the appearance of independence, but outside counsel will be protected from disclosure by the attorney-client and work product privileges. Advisers should not be the same individuals who act as outside counsel to the company’s management, creating a fundamental conflict of interest. The intricacies of corporate board duties require the guidance and assistance of disinterested, unrelated professionals.
Conflicts Of Interest – The Entire Fairness Standard
The most difficult issue for a director to avoid is the conflict of interest. Consequently, directors must learn how to deal with this inevitable situation. The four most common conflicts of interest issues faced by directors are:
- Doing business with the company
- Corporate opportunity
- Subsidiary insolvency
- Management buyouts
Directors are free to do business with the company as long as they fully disclose their personal involvement to the entire board in advance and as long as the disinterested directors make the decision to permit or disallow the director’s proposed business.
The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or noncorporate purpose, including to preserve the value of an investment. The 2015 Delaware Supreme Court case of Corwin v. KKR (and its progeny) held that a transaction that might be subject to enhanced scrutiny instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders (the “Corwin Doctrine”). Where a transaction is not cleansed by shareholder approval relying on the Corwin doctrine and where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.
In Delman, the court denied the argument that the transaction had been cleansed under the Corwin Doctrine. Rather, the court found that the proxy was materially false and misleading, such that the stockholders were not “fully informed” or “uncoerced.”
Some states, including Delaware, statutorily codify the duty of loyalty or at least the impact on certain transactions. Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter, (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement and all pertinent facts or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive informs both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resembles an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. Many companies obtain third-party fairness opinions as to the transaction.
Public Company Disclosures
All Exchange Act reporting companies must comply with SOX Rule 404(a), which requires the company to establish and maintain internal controls over financial reporting and disclosure control and procedures and have their management assess the effectiveness of each. This management assessment is contained in the body of all quarterly and annual reports and amended reports and in separate certifications by the company’s principal executive officer and the principal financial officer.
Moreover, Section 13(d) of the Exchange Act and the rules promulgated thereunder require any person or group that directly or indirectly acquires beneficial ownership of more than five percent of a Section 12 registered equity security to file a statement with the Commission disclosing certain information relating to such beneficial ownership. Section 13(d) is a key provision that allows shareholders and potential investors to evaluate changes in substantial shareholdings. The duty to file is not dependent on any intention by the stockholder to gain control of the company but on a mechanical five percent ownership test.
In addition to Section 13 obligation, Section 16(a) of the Exchange Act and the rules promulgated thereunder require officers and directors of a company with a registered class of equity securities and any beneficial owners of greater than 10 percent of such class to file certain reports of securities holdings and transactions. Under Section 16, every person who is an officer, director or beneficial owner of more than 10 percent of equity securities of an issuer must file an initial statement on Form 3 within 10 days of the event triggering such filing and continuing changes on Form 4 within two business days following such change. In addition, Section 16 also requires insiders to pay over to the reporting company any “profits” realized from any purchase and sale (or any sale and purchase) of the reporting company’s securities within a six-month period (under Section 16(b)). Under Section 16(c), insiders are precluded from making short sales (sales of shares they do not own at the time of the sale) of the reporting company’s securities. Moreover, the SEC requires that the reporting company disclose in its annual proxy statement the names of insiders who have failed to make required Section 16 filings on a timely basis and also note the existence of such disclosure on the cover of its annual report on Form 10-K.
Trading In The Company’s Securities
A director or officer may never buy or sell the company’s stock when he or she is in possession of material nonpublic information. Directors and officers are always advised to consult with legal counsel prior to buying or selling their company’s stock to ensure that they are not unwittingly violating the SEC’s strict insider trading rules.
Inquiries Of A Technical Nature Are Always Encouraged
The attorneys at ANTHONY, LINDER & CACOMANOLIS, PLLC, understand the needs of corporate officers and directors. The time to establish a relationship with personal, outside counsel is before a problem arises, not after. The guesswork is then removed, and the stress of having to scramble to find experienced and aggressive legal counsel during a time of crisis is eliminated as well. Contact us now by sending an email inquiry or calling our firm’s office at 877-541-3263.