The Role of Company Directors - Essay Example

 Introduction The current global economic crisis which was preceded by several unethical accounting practices in prominent international corporations has brought into sharp focus the fiduciary role of corporate directors who have been accused of engaging in frequent unethical acts including awarding themselves hefty allowances even as their companies faced foreclosures. Contemporary company directors are now been held liable for the excesses and losses incurred in diverse corporations as they share the blame with their management team on company failures and latent misuse of funds. The role of company directors has been mainly based on their fiduciary duties. Fiduciary duty is inherent amidst the interaction between directors and their company, trustees and their trusts, and lawyers and their customers. Barnet (2008) has defined fiduciary duty as a model of care observed in a legal correlation of faith and assurance involving an individual in a position of control, authority or influence, and another who is reliant on the appropriate exercise of that power...intrinsic in fiduciary duty is the accountability to perform in excellent confidence and honesty, the duty to work in the interests of the principal and to shun self-dealing transactions, and the commitment to not wield unreasonable demands or to proceed without the awareness and blessing of the principal. In a landmark case involving Caremark International Inc.1996 by the Delaware Chancery Court, the role of company’s directors was expanded to encompass liability in monitoring the company’s operations or ‘oversight liability’. This in effect meant that the directors had a fiduciary duty of closely supervising or overseeing the company’s daily transaction thus had to keep up-to-date on the regular operations of the corporation. The Delaware Supreme Court’s decision, Stone v. Ritter [Del. Supr., Jan. 27, 2009] upheld that the directors’ failure to ‘act in the face of a known duty to act’ is a breach of the duty of loyalty. To stem the excesses of the corporations in US, the Sarbanes-Oxley Act was enacted even as the courts stepped up punitive actions on errant directors and firms engaging in fraudulent activities. As a consequence many directors are increasingly getting more involved in the company’s operations to offset being charged with negligence and abdication of their fiduciary duties (Rehfeld, 2005). A corporation is owned by investor shareholders who are compelled to elect two directors to represent them in decision making. The directors’ duties include: To summon periodic statutory, yearly general meeting (AGM) and also special extraordinary general meetings; To organize and locate the AGM, financial statements including accounts of company's affairs and that of the Board of Directors; To validate and endorse yearly financial statement; To assign primary auditor of the corporation; To assign expenditure auditor of the corporation; To formulate a pronouncement of solvency in the case of a shareholder’s intended termination The board's primary function is to guarantee the corporation’s success by jointly overseeing the business transactions, whereas gathering the appropriate interests of its shareholders and stakeholders. Many corporations rotate the director’s position on an annual basis however a most have a vested interest in the firm, are employed in the higher echelons of the firm and are autonomous from the firm’s but are acknowledged for their entrepreneur aptitude. Fiduciary duties encompass the elected trustees to observe the following principals: Act in the paramount excellent devotion to their principal Not authorised at making a earnings from the trust assigned to him; Avoid instances of conflict of interest in their duties; Avoid undue benefit or assignment to a third party without the knowledge permission of the principal. The fiduciary duty compel a company’s board of directors to exercise careful observation of minimal issues of personal conflict by avoiding self-interest to influence their actions, gratuitous advantage of their position within the company and apply reactionary and not dogmatic attitude against the ‘principle’ or shareholders (Gillhams, 2008). As a consequence the fiduciary is governed by the following guidelines: The fiduciary is not permitted to compensation in the course of their duties hence any imbursement will be as per the contractual engagement. Any unethical transactions undertaken by the fiduciary can be annulled by the principal until the fiduciary expressively proves that they are not aimed at personal benefit hence will require full and candid disclosure to be considered reasonable and sincere. Trading of the principle’s assets to either of the trustees/directors can be annulled at the option of the recipient. The fiduciary trustee however is authorized to be indemnified for any extra charges accrued in the course of his duties. The role of a company director has moreover evolved in recent years from the laidback inexplicable position of yesteryears to a more engaged and conscientious role whereby the directors of a company are held liable for any actionable act of omission committed within the company whether they are directly responsible or not (QBE, 2002). The conventional view of the fiduciary duties of a company’s board of directors progressed from common law perspective is twofold: the duty of loyalty and the duty of care. Black (2001) has further expanded this to include two additional elementary duties that are quite relevant in contemporary organisational structure: duty of disclosure and the duty of extra care [See summary Figure 1]. Figure1 The first two duties can be categorised as responsibilities to the shareholders while the latter can be classified as responsibility to third parties. Nonetheless injury to third parties by company ‘agents’ whether directors or line employees is covered in law through the provision of ‘dual liability’. nonetheless it has been rarely strictly observed as most aggrieved parties prefer to seek redress by suing the company ‘deep pockets’ rather than the actual culprit thus meaning that they suffer minimal sanction. The recent ruling by the Delaware Supreme Court in Gantler v. Stephens, 2008 WL 401124 has nevertheless significantly reversed the trend as regular staff of corporations face direct liability for their actions (Cholst, 2009). While discharging their fiduciary duties, the company directors are expected to apply the ‘business judgment rule’ which alludes to the fact that they have acted in a knowledgeable basis, in good faith and to the best interests of the company. The rule states that ‘a director who exercises reasonable diligence and who, in good faith, makes an honest, unbiased decision will not be held liable for mere mistakes and errors in business judgment.’ This ‘business judgment rule’ implies that the directors do not engage in any fallacious manner hence the onus is on any dissenting person to prove otherwise in a court of law by clearly establishing facts to support such allegations (Huebner and McCullough, 2008). Although many public companies prefer to utilise independent non-interested directors to negotiate deals involving them, (Bhagat and Black, 2000) in a working paper on the ‘review of conflict-of-interest transactions’ however argue that such actions have minimal impact on the performance of the company as compared to those having less independent directors. Duty of Loyalty Royce (1908) quoted in DeMott (2006) defines loyalty as ‘the willing and practical and thoroughgoing devotion of a person to a cause...justice, charity, industry, wisdom, spirituality, are all definable in terms of enlightened loyalty’ (Pg.1). The most significant of the fiduciary duties for the company directors is that of loyalty to the organisation whereby the directors are obliged to act in the best interests of the company hence curbing any personal dealings with the company that may lead to a conflict of interests. This ideal is crucial in ensuring the directors do not engage in ‘self-dealing’ transactions which in actual fact will mean that they are unfairly dealing with themselves thus cannot be really fair or subjective due to personal interest. Although most jurisdictions have proscribed such transactions, it’s often an ambiguous regulation especially in small firms where the director’s role may be analogous to that of line employees. The remedy for breach of these rules or engagement in unfair transactions is usually damages if the courts deem the deal to be unfair (Black, 2001). Duty of Care In the application of the fiduciary duty of care, the company’s directors are expected to exercise in accordance with Section 214(4) of the Insolvency Act 1986, ‘ordinarily careful and prudent men would use in similar circumstances’ (Huebner and McCullough, 2008, Pg.6). In reference to the fiduciary duty of outmost care, Cupitt and Garret (2009) have argued that modern company directors are required to keep abreast of current issues within the organisation though observation of the following key elements: Knowledge of any new operations that may influence the firm’s performance especially if heavy funds are to expended; Obtaining periodic fitting legal and accounting counsel where necessary; Full participation in the board deliberations; Engaging the company’s management and employees in discussions concerning the company’s performance and direction; and Making certain that they have current financial information hence able to appropriately predict future performance. Through keen observation of the company’s operations, the following can serve as dire warnings to the board to ascertain whether the organisation is in trouble. Difficulty settling business contractor’s and other creditors fees; Difficulty settling credit obligations promptly or confining to the firm’s overdraft limits; Lawsuits against the company by contractors and other creditors due overdue financial payments and other commitments; Minimal operational funds from the company operations; Trading contractors denying the firm additional credit due to poor repayments; Trading contractors demanding COD; and, The firm being unable to meet its group tax, employee remuneration reimbursement premium or BAS statements punctually. Prudent company directors therefore avoid such scenarios hence are able to offset financial crisis hence can be said to be observing their fiduciary duties. The Institute of Directors (2008) has outlined the principal duties of a company’s board of directors in four major categories: Formulating the company’s tactical goals and strategies; Overseeing development towards accomplishing the strategic goals and plan; Assigning senior organization duties; Accounting for the organisation’s performance to all the pertinent stakeholders (e.g. the shareholders). Heidrick & Struggles (2006) nevertheless assert that the role of CEO succession planning is the second most important job of the company directors apart from their fiduciary duties. The directors are obliged to competitively source for a competent CEO that will engage a capable management team in line with the organisation goals and objectives (Pg.11). In an introduction to the Companies Act 2006 - Part 10 on the duties of company directors, the Minister of State for Industry and the Regions, Margaret Hodge has outlined some eight point guidelines for the directors that summarises the expected practice in the Act. The new Act also took into consideration the welfare of line staff whereby the directors were duty-bound to always consider their interests in line with those of the organisation and shareholders unlike previously when only the interest of the owners (shareholders) were considered requisite. Breach of Fiduciary Duty A breach of the fiduciary duty occurs when the directors fail to comply with the requirements of acting in the best interests of the stakeholders. In instances when the board of directors neglect to closely monitor the activities of the organisation’s management hence leading to gratuitous loss, they are reckoned to have contravened their fiduciary duties. In recent Court of Appeal ruling Lexi Holdings Plc (in administration) v Luqman and Others [2009] EWCA Civ 117, the court upheld the view that when one of the directors of a company acted inappropriately, the other dormant directors can still be held accountable for breach of duty even if inactive in the transaction hence ignorance cannot be considered as a viable defence. Directors who allow themselves to be coerced or subjugated by their more aggressive colleagues are assumed to be in breach of their duty by virtue of their inactivity (Garrett and Cupitt, 2009). The Delaware Supreme Court in recent ruling, Gantler v. Stephens, 2008 WL 401124 issued January 27, 2009 similarly upheld that company directors have personal liability for breaches of duty of care to the company and its shareholders. Although merger deals are protected by the Business Judgement Rule, the company’s board of directors refusal to sell the company in a lucrative deal in order to preserve their own interests when the purchasing company sought to replace them was therefore construed as unethical and a breach of their duties (Institute of Directors, 2008). This ruling exposes company officials to litigation although unlike the directors, they are not indemnified by the ‘exculpatory’ charter provisions [DGCL Section 102(b) (7)] that protect the directors from such liability. The breach of the fiduciary duty also occurs when the directors engage in self-dealing whereby the directors unethically gain at the expense or disadvantage of the company or the owners. The breach of fiduciary duties renders the company open to litigious lawsuits from the shareholders who can either sue the entire board or an individual director. Some these cases of loyalty breaches consist of when director(s) have a concealed knowledge in a particular transaction, the directors deny the company prospective gains that could be beneficial, directors obtaining anonymous intermediary fees (e.g. broker’s fee) for assisting in transactions relating to the company and directors rewarding themselves disproportionately at the company’s expense. In the ALENCO (Holdings) Ltd & ors v Bates (2005), the company’s financial director was held liable for breaching his fiduciary duties through fraudulent acts by dipping in the company’s pension funds amounting to over £700,000 and was directed to repay the claimants. Although the directors of a company are duly covered through indemnity insurance for any punitive actionable acts of omission in the company, they rarely enjoy the cover if they are found to have actively participated in unlawful violations of their fiduciary duties as they are only indemnified for negligence, default and breach of duty. The penalties enjoined are therefore severe and are issued solely to specific individual directors implicated in the unethical infringements. Thus the Business Judgment Rule does not screen the directors from legal action if they engage in improper acts or in a mala fide manner (Cholst, 2009). In Bamford v Bamford (1969) UK, the courts held that, when a company’s board of directors convey full and frank disclosure to the corporation owners or shareholders, they can be considered to have acted in good faith so long as the action was not ultra vires to the corporation altogether. Company directors are supposed to exercise their duties in line with the provisions of the Companies Act, Memorandum and Articles of Association and also in cognition of guidelines of the board of directors. These form the ultra vires acts that serve as the guiding principle for directors to observe careful adherence to rules and statutes to avoid exploiting their position in selfish regards. In the United Kingdom, the shareholders of the company are sanctioned to dispose of errant directors who contravene their fiduciary duties as upheld in the c.f. Bushell v. Faith [s.168 CA 2006]. To avoid directors extended stay in position of power, Art.20 of the Model Articles necessitates that one third of the board of directors to seek re-election annually which means that they can only serve for a maximum period of three years while a mandatory ten percent of shareholders can force a shareholders meeting at any time whilst five percent can demand a meeting if an twelve months have elapsed since the last occurrence. These meetings are used to weed out unpopular board members thus ensuring the directors do not become complacent in their dealings [s.303 CA 2006]. In case minority shareholders consider they are being intimidated through the application of the majority rule particularly by single or small group of influential shareholders who have controlling grip on the board members, they can initiate a derivative action if they consider the company is being badly managed as in Foss v Harbottle (1843) [2 Hare 461]. Legal action can lead to courts awarding the aggrieved parties a constructive trust, an account of proceeds or an equitable reimbursement (Ong, 1999). Conclusion Contemporary company directors are required to exercise an active role in the operations of the company as they are increasingly being held culpable for failures within the organisation. Fiduciary duties compel them to be fair and loyal in their elevated role as the custodians of the shareholders while other stakeholders expect them to be observant of the management of the firm. The onset o the current financial crisis has been blamed on the negligence and involvement of the coporate boards inconjuction with the management to careless execution of their duties against the laid down regulations and attiquate normally required. Although the provision of fiduciary duties in the role and operation of company’s board of directors my seem to be tillted in favour of the shareholders, various jurisdictions have exercised due diligence in awarding frivolous ligation against the directors who will be constricted and fearful of any acts of ommission or commission. In the revised UK Companies Act 2006, the provision for due regard for the directors inability as opposed to lethargy has been emphasized as ruled in the case of Equitable Fire that was judged to be of ability and not conscientiousness proclaiming that, ‘such care as an ordinary man might be expected to take on his own behalf.’ Norman v Theodore Goddard [1991] [BCLC 1027]. Nonetheless modern company directors have to be observant and proactive in the running of the corporation affairs to avoid unnecessary censure and liability. References Barnett, J. A. (2008). Fiduciary Responsibility of Association Directors: Practical Application of Legal Theory . Retrieved February 15, 2010, from Hoa-law.com: http://www.hoa-law.com/publications.shtml Black, B. S. (2001). The Principal Fiduciary Duties of Boards of Directors. Third Asian Roundtable on Corporate Governance (pp. 1-13). Singapore: Stanford Law School. Black, S. B. (2000). Board Independence and Long-Term Performance. Retrieved February 15, 2010, from SSRN.com: http://papers.ssrn.com/paper.taf?abstract_id=133808. Cholst, B. A. (2009). Is Your Board Carrying Out Its Fiduciary Duty? Retrieved February 15, 2010, from Cooperator.com: http://cooperator.com/articles/178/1/Is-Your-Board-Carrying-Out-Its-Fiduciary-Duty/Page1.html/addfav Cupitt, S. G. (2009). United Kingdom's Directors´ Fiduciary Duties: Inactivity May Be A Breach Of Duty. Retrieved February 15, 2010, from Mondaq.com: http://www.mondaq.com/default.asp?section_id=1&product_id=1 DeMott, D. A. (1995). Breach of Fiduciary Duty. In J. Royce, The Philosophy of Loyalty (p. 9). Vanderbilt Univ. Press. DeMott, D. A. (2006). Breach of Fiduciary Duty: On Justifiable Expectations of Loyalty and their Consequences. New York: Duke University School of Law. Gillhams. (2008). Fiduciary Duty Equity . Retrieved February 15, 2010, from Gillhams.com: http://www.gillhams.com/dictionary/487.cfm Gutierrez, M. (2000). A Contractual Approach to the Regulation of Corporate Directors' Fiduciary Duties . Madrid, Spain: CEMFI, Cesado del Alisal. Heidrick & Struggles. (2006). The Board of Directors Role in CEO Succession Planning. Heidrick & Struggles. Institute of Directors. (2008). The duties, Responsibilities and Liabilities of Directors. London: IoD/Ernst & Young. Lexi Holdings Plc (in administration) v Luqman and Others, Civ 117 (EWCA 2009). McCullough, M. H. (2008). Fiduciary Duties of Directors. London: Davis Polk & Wardwell and Global Legal Group Ltd. Ong, D. S. (1999). Breach of Fiduciary Duty: The Alternative Remedies. Retrieved February 15, 2010, from Austlii.edu.au: http://www.austlii.edu.au/au/journals/BondLRev/1999/21.html QBE. (2002). The Role of Company Director and Officer. Sydney: QBE Directors & Officers Liability Insurance. Rehfeld, J. (2005). The View From The Boardroom. The McKinsey Quarterly . Wong, S. (2009). Forgiving a Director’s Breach of Duty: A Review of Recent Decisions. Perth: Corrs Chambers Westgarth. Read More