One who occupies the role of director in a California corporation is required to exercise a duty of due care in performing his or her role as fiduciary to the company. As discussed in other articles on this website, the “fiduciary duty” imposes the highest duty known to law-what a lawyer has to a client, a parent to a child, a trustee to a beneficiary. And a director to the company.
The director is required to act in the best interests of the company and exposes him or herself to personal liability if he or she fails to so act. Any conflict of interest is prohibited and the director, while not guarantying success of the company, must show reasonable business judgment in making decisions for the company. Attending meetings, participating in the decisions required of the board of directors, and voting on the issues at hand are the standard duties imposed upon such a director. The director is certainly allowed to be wrong in decisions but cannot be wrong due to neglect of duty.
And many serving in that role are unaware that the duty involves an even more active role-the duty to make reasonable inquiry. That topic is the subject of this article.
The Duty of Reasonable Inquiry:
Most directors meet annually or quarterly and attempt to generally supervise the actions of the officers of the company and the general condition of the company in that manner. Recall that it is the officers, not the directors, who operate the day- to -day activities of the company. Absent an employment agreement, the officers serve subject to approval and appointment by the directors, usually confirmed annually. Most directors see themselves as divorced from day- to- day operations, only called upon once a year to give strategic input and consider and approve or disapprove long term plans and goals. A standard part of the annual meeting is to approve the acts of the officers taken in the year prior to the meeting.
Directors are elected by the shareholders, usually serving for one year terms, depending on the bylaws of the corporation. The directors, in turn, hire or appoint the officers. Often directors are shareholders, and, at times, also officers. They need not be shareholders or officers. Directors can be but often are not compensated for their duties, often serving as a favor to the shareholders or are, themselves, shareholders who wish to be involved, at least strategically, in the operations of the company.
In California, shareholders usually do not have a fiduciary duty to the corporation or the other shareholders. They are owners and the duty of due care is owed to them by the directors and officers. In California, a majority shareholder may have a limited duty to the minority shareholders in certain circumstances, but that is the exception. This one sided nature of owing a duty is vital to understand in considering the role of directors. The shareholders elect the directors, but it is the directors who owe the duty of loyalty to the company, hence the shareholders.
Many directors see their role as passively receiving and reviewing reports and financial information delivered by the officers of the company and making decisions based on the information received. It is common for officers to provide written reports on the condition of the company prior to the annual meeting. The directors should review those reports carefully and pose appropriate questions. If no such report is received, the directors are not capable of making informed decisions as to the company, of course. Many directors insist upon receiving audited financial records of the company as well.
But this relatively passive role for directors can conflict with their actual legally imposed duty to the company. The directors are required to do more than just meet annually and accept at face value the reports of the officers. The directors are required to protect the company and can not just let the officers or employees of the company act without any active and intelligent director supervision at all.
The directors are required to make reasonable inquiry as to the condition and activities of the company. They not only must review the reports delivered (and demand such reports if none are delivered) but must make such inquiry as the reports or conditions of the company seems to require.
Examples of such active inquiry may illustrate this duty best.
Assume the financials report that sales have decreased by twenty percent because the company has withdrawn from a particular geographical market. No other information is provided in the report, just the decline in sales coupled with a foot note that this abandonment of a market largely explains the decline.
The director receiving that report would be required to inquire as to the reasons for the withdrawal from the market, how the reduction in sales will affect the company, and what steps the company is taking to overcome that reduction. The director may also insist that before any other withdrawals from any other markets are implemented, the director wants a meeting of the directors to consider the action.
Let us assume that the CEO of the company responds in the meeting that the particular market had generated sales but no significant net profit due to the added cost of shipping and the competition in that market. The CEO explains that the net profit of the company has improved even though sales have declined overall.
The director might accept that explanation or may further inquire as to why other companies are still able to successfully sell into that market, whether alternative shipping arrangements could be created and what other markets are being considered by management to make up the lost sales.
Another example: The CEO announced that an embezzler in the accounting department has stolen over a hundred thousand dollars in the last year and they have turned him into the police. The director should inquire as to the method of theft, how it was not discovered until a hundred thousand dollars was taken, what corrective steps have been taken, whether an insurance claim has been made and whether legal steps to recover from the embezzler have been commenced.
But merely raising questions based on reports received may still not be enough.
Once a report is received from the company, the director is required to examine it closely and determine if there is anything in the report or financials that requires inquiry. Let us assume that the CEO declared a sizable bonus for key executives, a bonus that cut in half the dividends likely to be available for the shareholders. The director should not only question the CEO as to rationale for the bonus and how the amount was computed, but should, on his or her own, investigate the current level of compensation for persons in similar fields in the geographic area and determine if the bonus is within the realm of reasonableness and, again, may insist that any bonuses to key managers be approved by the directors prior to being declared.
There are myriad other examples that could be given, but the concept is that the director is not a passive recipient of information. The director’s duty to the company requires the type of reasonable inquiry that a prudent business person would take in advising and approving of actions of the company.
Only Reasonable Business Prudence is Required:
The duty does require active inquiry and involvement by the director but does not impose upon the director that he or she is always right or made the right decision. The courts have long recognized that business people make mistakes, including fiduciaries, and that while due care must be taken by a director, the care is the duty, not a guaranty of results.
Or, as one judge put it, “You don’t have to always be right. But you have to have a good reason why you were wrong based on your examination of the facts on the ground.”
What if the Officers Will Not Cooperate?
Usually the information derives from the officers and agents of the company, such as the CPA. What happens when they refuse to provide information to the director?
The board of directors is the entity that selects the officers. If an officer refuses to provide relevant information, that officer may be in breach of his or her fiduciary duty and liable to termination or even damages due the company. The director must actively seek relief, calling a meeting of the board and demanding that the board require the officer to provide the key information. The bylaws of the company will indicate how such a special meeting of the board is called.
At times, the officer, himself, is a member of the board and is able to convince the majority of the board to not support the director requesting the information. The director, however, can insist that the officer who is a director may be in conflict of interest and should recuse him or herself from voting on the topic. If they refuse, the director can seek an order from the court or suggest to the other shareholders that they seek such an order.
A key aspect is that the director must make a full and accurate record of his or her efforts to protect the company and the shareholders and his or her written notice to the shareholders as to his or her concern and his or her inability to obtain access to information. (Avoid claims of slander or libel: unless you already have convincing evidence, make sure the communications clearly state you are investigating, not accusing.) It is vital that the director can prove at a later time that he or she took all reasonable steps to protect the company.
And if all this still does not provide information that the director needs, the director may have to resign, thereby cutting off further fiduciary obligations to the company.
Corporate “warfare” is a complex and chess-like procedure and the reader is advised to review the articles on this website on that topic.
Wise Conduct of Officers:
Many times officers of company come to our office outraged that their actions are being questioned by directors who are only occasionally involved in company business. They not only feel insulted but often consider the directors interfering amateurs who should simply remain quiescent.
We tell officers that a director must make reasonable inquiry. Unless the officer has good and valid reasons to refuse disclosure, such refusal will only escalate the dispute and could lead to costly and destructive litigation. Directors have duties that must be taken seriously. The officers should realize that.
If the officer does have good reason to decline information, that should be explained in writing with the knowledge that shareholders…and perhaps a court…will be examining the reasons. Both directors and officers can be held personally liable for breach of fiduciary duty, so a lot may be riding on this decision. As one CEO told the writer, “When in doubt, give them what they want…indeed, give them more than they want…”
There can be legitimate reasons to decline information. Giving out confidential information or trade secrets to a director who has not executed a non disclosure agreement or who may, him or herself, be in a conflict of interest, can certainly be refused and a system of disclosure to a trusted third party who will recuse the information may be a solution. But any director in a conflict of interest should be removed by the shareholders and the officer should so communicate to the shareholders his or her concern.
It is vital to understand that what appears to be a cover up can, itself, cause needless concern on the part of the shareholders or directors. Or, as one owner told the writer, “The CEO pulled a Nixon…made a little issue become catastrophic by refusing to disclose a piece of information that meant little…except to expose the CEO to far more scrutiny by a curious board of directors…”
Accepting the post of director requires a commitment to the duties inherent in that post. It is not just meeting in a conference room and having lunch. It requires attentive care for an entity that is depending on the director to be the protector of the shareholders and the law allows the shareholders to seek recovery if the director fails in that duty through negligence.
Most directors wish the company to obtain for the directors an errors and omissions insurance policy to protect them from the expense and possible liability that can derive from litigation as to their duties. The “E and O” insurance is usually not expensive and the wise director will insist upon that purchase before assuming the duties.
And if illness or personal plans make it difficult or impossible to fulfill the duties imposed, the wise director will simply resign.