The formal board vs. the advisory board
By Professor Charles W. Murdock, Loyola University Chicago School of Law
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The risk of legal liability should not be the
controlling element in deciding that type of
board is best for you.
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Many family businesses in recent years have recognized the value of having some sort of deliberative peer body to provide advice and guidance to management. In some companies that body takes the form of a legal board of directors--with a majority of independent outsiders chosen for their business experience and expertise. Other companies, aware of what appears to be a surge in litigation against corporate directors in recent years, have preferred to set up an advisory board of experienced outsiders.
The choice of an advisory board rather than a formal board is usually based, in part, on the owner's belief that it is easier to attract top talent to a body that presumably has no fiduciary responsibility and therefore cannot be held legally liable for its actions. Serving on an advisory board may no longer be entirely risk-free, however. If an advisory board functions like a board of directors--for example, when the CEO consistently follows board recommendations that are not well founded--the members could run the risk of litigation, if not liability.
Usually, the bylaws of an advisory board provide specifically that the members have no authority to act on behalf of the company and that its recommendations are not binding. The bylaws may also specify that membership is voluntary and can be terminated by the CEO. Presumably, the fact that an advisory board member has no authority and serves at the pleasure of the CEO means he or she should not be held accountable. In reality, the status
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Recommendations of a board are taken
more seriously when the members are
legally accountable.
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of legal directors is not much different. Today many corporate statutes provide that shareholders can remove directors, with or without cause. Since the CEO of a family company is often a controlling shareholder, he or she can usually fire a director through the process of a shareholder meeting. The mechanics are more difficult, but the results is the same. While the theory is that the board controls the CEO, the reality is that the CEO controls the board.
The risk of legal liability should not be a controlling element in deciding what type of board is best for a family company. While it is true that advisory board members are less likely to be sued than directors on a legal board, the risks to directors have probably been exaggerated. Much of the litigation brought against corporate directors in recent years has resulted from takeover offers or alleged misrepresentations with respect to market-sensitive information such as earnings forecasts. Since most family businesses are closely held, the likelihood of such public misrepresentations is minimal. Lawsuits involving bad decisions of the management and charging directors with violating the basic "duty of care" in their deliberations are, moreover, relatively rare. Courts simply do not want to be put in the position of second-guessing operating decisions of directors. That is precisely why they developed the "business judgment rule," under which courts defer to the judgments of directors in such cases--so long as those judgments were based on informed deliberation.
In addition, there are a number of ways of indemnifying directors who act in good faith against costly lawsuits. Under one approach, the corporation itself provides indemnification--that is, it promises to cover any judgments against directors for their actions. Another way is for the company to buy directors and officers insurance for its advisors. Since D&O insurance is expensive, however, it is probably not a realistic alternative for most family businesses.
Another alternative to indemnification is rarely discussed. The controlling shareholders who sit on the board can personally indemnify outside directors by pledging their stock to cover any judgments. The risks of such a strategy are minimal. Since the inside directors control the flow of information and participate in the board's decisions, they are not likely to sue the outside directors for their role in such decisions. The possibility of a so-called derivative suit by shareholders who do not sit on the board cannot be foreclosed, but if their holdings are not substantial, the indemnification provided by the inside shareholders should adequately protect the nonfamily outside directors from suits by minority shareholders.
I have served family companies both as an adviser and a formal director, and I have found that all parties take their responsibilities more seriously when they have legal authority and responsibility. Management will take budgets and forecasts more seriously and make operating decisions more carefully when it knows that they will be
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Controlling owners can personally indemnity
outside directors by pledging stock to
cover judgments.
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reviewed by an outside group. It is only human nature: Whenever people's actions are going to be closely scrutinized by peers whom they respect, they will be more diligent and circumspect. By the same token, board recommendations have more credibility and are taken more seriously when the members are legally accountable. That is a long way from saying, however, that the board controls operations and should dictate policy to the majority owners.
The theory of the outside board takes seriously the proposition found in all corporate statutes that "the business affairs of the corporation shall be managed by or under the direction of the board of directors." As is well known, it is extremely rare for public corporations to be truly managed by a board. In a closely held company, it is a total illusion. Management controls the flow of information in every company, and he or she who controls the flow of information controls the decision-making process.
What should be the composition of a legal board? While an outside board would normally have an odd number of directors, I favor a board that is balanced between three or four outsiders along with three or four insiders, who can be either nonfamily mangers of the company or members of the owning family. A balanced board combines the breadth and perspective of independent outsiders with opportunities for family members to participate in the decision-making process. For one thing, that means there are potentially fewer plaintiffs, since family directors are unlikely to sue themselves. But there are other benefits to having more rather than fewer family members on the board.
One is that when possible successors serve as directors, it affords the outside directors a change to get to know them better and to provide input into their development. Just as important, it helps potential successors and other family members understand policy deliberations and have the experience of being held accountable. Since key managers often report to the board, moreover, family shareholders are exposed to a wider range of information and opinions on the company's operations, rather than having everything filtered through the eyes of the founding father or CEO. While it might make sense in a public company for the CEO and the CFO to be the only insiders on the board, wider board participation by family members is essential in a family owned enterprise.
I do not believe that having an even number of insiders and outsiders on a board will inevitably result in deadlocks. If a formal board works at all in family companies, it works by consensus, as does an advisory board. Each of the two approaches has pluses and minuses. However, the most important consideration is that both bring peer review and the opportunity for new ideas and new ways of looking at how to do things into the system. For this reason, both are preferable to the stereotypical family board, which is dominated by the CEO and basically operates as a rubber stamp, if it functions at all.
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Charles W. Murdock, a professor of law at Loyola University Chicago, frequently serves as an expert witness in corporate and securities cases. He and his wife, Moni, work as a team consulting to family businesses.
Reprinted with permission, Family Business Magazine, Box 41966, Philadelphia, PA 19101-1966, Spring 1977, Copyright 1977, fambuspub.com.
BusinessLaw Flash PointsSM -- April
By Donna Cunningham
US Supreme Court II: State statutes providing for nullification of spouse as beneficiary in event of divorce pre-empted by ERISA.
During their marriage, husband named his new spouse (now Petitioner) as beneficiary under his employer's life insurance policy and pension plan. Following his divorce from Petitioner, husband failed to change his beneficiary designation before he died intestate. Relying on state law which automatically revoked a former spouse as beneficiary in the event of divorce, his children from a previous marriage filed suit, claiming the proceeds of the policy and pension plan. ERISA pre-empts all state laws that may relate to any employee benefit plan covered by ERISA. Finding that under the state statute, Administrators were required to pay benefits to the beneficiaries chosen by state law, rather than to those identified in the plan documents, in violation of ERISA, the U.S. Supreme Court held that the state statute was pre-empted, and the plan was required to be administered in accordance with the plan documents. Egelhoff vs. Egelhoff, No. 99-1529, March 21, 2001. http://supct.law.cornell.edu/supct/html/99-1529.ZS.html
Business method patents rejected by UK, fewer issued by U.S. Patent & Trademark Office.
After seeking public comment, the Patent Office of the United Kingdom has released its report and conclusions http://www.patent.gov.uk/about/consultations/conclusions.htm on the issuance of patents for computer software and business patents. The report concludes that software should be patentable only when there is technological innovation, and reveals that opposition to that the issuance of business method patents was virtually unanimous where no computer was involved, and strongly opposed for computer-implemented business method patents where no innovation was involved. Meanwhile, The Wall Street Journal reports that according to Esther Kepplinger, deputy commissioner of the US Patent Office http://www.uspto.gov/ for patent operations, the number of business method patents issued by the U.S.P.T.O. is down 56% in first Quarter 2001, after new policies were issued requiring a second review for such patent applications.
More on arbitration: arbitrator's decision, though "Unsound" was within arbitrator's authority.
Noting that its ability to review arbitrator's awards concerning collective bargaining agreements (CBAs) was strictly limited to determining whether or not the arbitrator had exceeded his or her authority, the 7th Circuit let stand the arbitrator's decision in favor of defendant-union in its interpretation of the CBA, even though the decision may have been "unsound." The court was not empowered to set aside the award since the arbitrator was only interpreting the CBA, which was within his authority. Northern Indiana Public Service Company vs. United Steelworkers of America, # 00-3208, CA 7th Cir., March 12, 2001. To read the case, go to http://www.ca7.uscourts.gov, click on "Judicial Opinions" and input case number 00-3208.
Insurance broker not agent of insurer, though named agent.
Broker chosen by Plaintiff to acquire business-interruption insurance was a named agent of insurer, pursuant to a signed agreement, but covering other types of insurance. Although Broker assured Plaintiff that he had acquired the correct insurance, it failed to cover Plaintiff's losses. Even though Broker signed documents and collected premiums on behalf of insurer, Plaintiff did not show that Broker was agent of insurer for underwriting purposes for purposes of this type of policy. Archer Daniels Midland Company vs. Hartford Fire Insurance Co., # 98-1608, CA 7th Cir., March 14, 2001. To read the case, go to http://www.ca7.uscourts.gov, click on "Judicial Opinions" and input case number 98-1608.
Temporary staffing agency had no mechanic's lien rights.
Adopting the reasoning of a Colorado Court of Appeals, the Illinois Appellate Court has ruled that a temporary agency providing contract workers for a construction project has no mechanic's lien rights for work done on the project. Even though the temporary staffing agency provided workers for the construction site, they did not assume any responsibility for performing work on the site, and so are not entitled to Mechanic's Lien rights. Onsite Engineering & Management, Inc. vs. Illinois Tool Works, Inc., No. 1-00-0786, Ill. App., 1st Dist., February 8, 2001. To read the case, go to http://www.state.il.us/court/Opinions/AppellateCourt/2001/, click on February, under 2001, and search for the case name.
Bankruptcy bill aims at Florida's unlimited homestead exemption, corporations' right to form reorganization plan, retailers' sale of leases.
House Resolution 333, and Senate Bill 420 both seek to reform the Bankruptcy Code in dramatic ways. Supporters of the proposed new federal bankruptcy law say that it is necessary to prevent the kind of abuse caused by Florida's unlimited homestead exemption, which permits a potential bankruptcy to buy a luxury home and keep it even after filing for bankruptcy protection. The House Bill would set an 18 month time limit on the right of a corporation in Chapter 11 reorganization to come up with its own reorganization plan, after which creditors could propose their own plans. It also sets a 120-day limit on the right of a retailer to decide whether to sell its leases or turn them over to the landlord. Both the House and the Senate have passed their separate versions of the bill, and President Bush has said he will sign it, but the bill is now stalled by the 50-50 split in the Senate. See the Bankruptcy Abuse Prevention and Consumer Protection Act of 2001 (HR 333), and the Bankruptcy Abuse Prevention and Reform Act of 2001, (SB 420). Go to http://thomas.loc.gov and search for the bill number.
UCITA in Illinois dies quick death, while New York attorney general declares it void and unenforceable.
UCITA in Illinois, HB 3058 http://www.ilga.gov/scripts/imstran.exe?LIBSINCWHB3058, has been re-referred to the Rules committee, which means it is dead, at least for this year. Meanwhile, in New York the Attorney General has declared the law detrimental to New York consumers, and void and unenforceable if one of the parties to a contract under UCITA is a New York resident. As reported in BNA's Electronic Law and Commerce Report.
Where are they now?
Proposed HB 3057 http://www.ilga.gov/scripts/imstran.exe?LIBSINCWHB3057 reported here last month, would repeal the Uniform Arbitration Act and create the Uniform Arbitration Act (2000). It has been re-referred to Rules, so it is dead for this year. SB 659 http://www.ilga.gov/scripts/imstran.exe?
LIBSINCWSB659 proposing to amend the Criminal Code to create the offense of "reckless corporate conduct" is now dead. SB 575 http://www.ilga.gov/scripts/imstran.exe?LIBSINCWSB575 amends the Illinois Securities Law of 1953, and is still alive. Senate Bill 725, http://www.ilga.gov/scripts/imstran.exe?LIBSINCWSB725 proposed by the office of the Secretary of State, makes numerous changes to the business entity acts, and is almost certain of passage. Included are changes removing employees and agents from the mandatory indemnification requirements of the Business Corporation Act, tracking recent changes to Delaware's corporate law. All Senate bills must be out of committee by March 30, or they are dead. By April 6, all House bills must be in the Senate, or they are dead. To check status, go to the Illinois General Assembly Site at http://www.ilga.gov/legisnet/legisnet92/92gatoc.html and enter the bill number.
Food for thought.
Is it time for "all-state attorneys?" Given the increasingly global nature of business, and the growing jurisdictional problems of doing business over the Internet, why not? The American Bar Association and the Florida Bar Association are both reviewing the matter, in view of the recent California decision, reported here previously, that New York lawyers handling an arbitration in California for their clients were practicing law without a license. The link to this article is too long to be posted here. Please go to http://www.law.com/, and search for "all-state attorneys."
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