This article originally appeared in the Director Journal, a publication of the Institute of Corporate Directors (ICD).
The jobs may sound similar, but the underlying risks are very different.
What are directors' duties across various corporate forms, and how should directors protect themselves from the distinctive risks they may encounter? This article will tackle these subjects at a high level; for the 750-page version, see my Directors' Duties in Canada, 4th Edition, published by CCH in 2009.
Directors' Legal Duties
All corporations, from public companies through private companies, Crown entities (corporations and agencies), and charities, tend to impose two basic legal duties. The Canada Business Corporations Act (CBCA ) is typical:
- Directors, in exercising their powers and discharging their duties, must act honestly and in good faith with a view to the best interests of the corporation, and must exercise the care, diligence and skills that a reasonably prudent person would exercise in comparable circumstances;
- Directors must act free of conflict, disclosing the nature and extent of any interest they have in a material contract or transaction made or proposed with the corporation and (with limited exceptions) recusing themselves from the voting on those issues.
Applicable legislation usually goes on to provide other specific obligations, including liability for unpaid wages, corporate distributions during insolvency, failure to withhold or remit a variety of taxes, and endangerment of workers or failing to prevent pollution.
Directors' Duties in Practice
(i) Public Companies
While directors must and do pay attention to their legal duties, these duties tend not to be the most top-of-mind or complex in terms of discharging a director's duty or protecting against director liability. The "easy case" is that of a widely-held, publicly traded corporation. There, the applicable statutes require the existence of a multi-person board, an audit committee comprising (a minimum of three) independent and financially literate directors, and (practically speaking) compensation and corporate governance committees.
Many obligations of the board and of these committees are specified by law. The directors' primary duty is to maximize shareholder value (although Canadian courts have frequently said that directors should pay attention to other interests, ranging from those of customers, suppliers and employees through those of the environment and the communities in which the corporation does business). Directors shield themselves from legal liability by following processes outlined in governing regulation or generally accepted practices. Thus, for instance, directors avoid liability for tax and other withholdings by obtaining compliance certificates from executive officers; this "diligence" provides a defence to the liability.
Elsewhere, directors seek the protection of the "business judgment" rule, pursuant to which decisions of directors will be respected, and legal liability will be avoided, so long as directors acting in the absence of conflicts take adequate time and care in addressing questions before them. In these cases, a court will not substitute its judgment for that of the directors.
Allegations of negligence are a concern for directors of public companies, and increasingly so. While lawsuits naming directors were infrequent in Canada as recently as a decade ago, something like one-quarter of public companies are now subject to directors' liability claims. However, directors of solvent companies who have the benefit of well-drafted corporate indemnities do not face real liability exposure, nor do directors elsewhere, if they are protected by suitable directors' and officers' insurance programs.
Directors have begun to pay attention to the form of their indemnification and to details of their insurance programs, recognizing that these are not commodities but custom contracts that require the involvement of unconflicted advisers who are expert in the field. Directors, either individually or as a board, frequently retain independent external counsel to act for them in developing suitable forms of indemnification contracts and to establish appropriate insurance procurement processes. These should result in directors' and officers' insurance programs that fairly balance the somewhat conflicting interests of management, management directors and independent directors, as well as address the intricacies of the treacherous wording of insurance contracts to ensure that coverage is available when it is expected to be. Few, and possibly no, directors in Canada have had to satisfy a liability claim from personal funds.
With indemnification and insurance in place, directors need only fear legal liability in the sense of having to commit substantial time to the defence of a claim. Their real potential liability tends to be to regulators, the media, and their own reputations. Regulators often establish standards for directors' duties, and may do so on a subjective basis that takes into account the differing skills and experiences of, say, a financial expert who leads the audit committee and a businessdomain expert who is one of many directors on the board. The media have become interested in corporate affairs, and quickly ask, "Where were the directors?" when things go wrong.
In my personal experience as an adviser and as a director, the real motivator of directors is concern to do what is right, and to protect their own reputations in consequence. This concern causes directors to seek independent advice when their customary advisers, including internal or external counsel who may be or seem too tied to management, appear conflicted. Directors establish independent board leadership (separated chair and CEO roles, or a lead director role), engage their own audit and compensation consultants, seek independent representation on matters ranging from indemnification and directors' and officers' insurance to CEO succession, and form special committees quickly when specific issues appear to have the potential to create conflicts with management or among various directors.
So, looking at the concerns a public company director may have, the following advice should be considered:
- Be alert to conflict concerns.
- Ensure that the board functions independently and sets and pursues its own agenda, an agenda different from that of management.
- Take the time to do your job properly.
- Exercise your own judgment, independent of management, independent of your advisers, and independent of your fellow directors when necessary.
- Document what you have done, including during in-camera sessions. Contemporaneous recording of the work the board has done is extremely helpful in establishing that directors have discharged their duties, in all of the different arenas in which the directors might be challenged.
- Be sure that you have suitable contractual indemnification and directors' and officers' insurance. And be careful to ensure that you are represented in this by someone who is unconflicted and clearly acting for you.
(ii) Private Companies
At the other end of the spectrum is a private company, 100% owned by an individual shareholder. There is usually no need for a "board" of directors; the shareholder can be the only director. While many of the employment, tax and environmental liabilities will apply to this director (who also tends to be in charge of them as an executive), the duties of care, fiduciary duty and conflicts rules are not particularly relevant.
Owners develop private-company boards for a variety of reasons. The owner may wish to attract advisers who will commit to participate or be more intimately involved if they function as directors (rather than as ad-hoc sounding boards or as an advisory board). The board may be part of a succession-planning exercise – the presence of the board assures employees that there will be some continuity if the shareholder retires or passes on, and may allow for training of successor directors and executives. Boards are often created as companies grow, whether to expand the capacity of the oversight role or because of the involvement of partners or investors who insist on more formal governance.
Another example of companies of this sort is the Canadian subsidiary of a U.S. (or multinational) parent. A "compliance" board, comprising enough Canadian directors to satisfy corporate law requirements, is often needed. The parent may want this board to be a formality, or may seek to extract value from it, particularly as an advisory body on distinctively Canadian issues.
Directors of private companies do have legal exposure, including the specific employment, tax and environmental liabilities noted above, and liability to the sole shareholder (in a case in which director disagreement with the owner delays or defeats an owner's purpose) or to the other constituencies to which the directors are responsible (a particularly relevant consideration in the Canadian subsidiary context). Accordingly, directors of private companies should have contractual indemnification and appropriate directors' and officers' insurance.
However, the real exposures here are more those of disappointing someone, reputational damage or regulatory liability. The disappointment may be to the sole shareholder, who appointed the director in the first place, looking for some of the benefits listed above. The disappointment may be to third parties, including other investors, lenders, employees, customers or suppliers, who were looking to the director to bring responsibility and discipline to a previously one-ruler environment. Or the disappointment may be to the director personally, who may determine that he or she is wasting time in a situation in which the owning or controlling shareholder has no real interest in the director's views. Directors also find themselves in a difficult position when the best interests of a subsidiary conflict with the wishes of its parent.
The best path to avoiding liability here (apart from compliance with applicable processes referred to above in the discussion of public companies) is:
- Achieve clarity in discussions with the controlling shareholder about their expectations of directors. Establish why the board is being created, and what sorts of contributions are expected.
- Enforce the ground rules so established, including in cases in which the shareholder may not want to be advised or contradicted. Directors often have to deliver difficult messages (sometimes including a need for succession or for independence) to those who appointed them.
Of course, many private companies have several, or even many, shareholders. As the number of shareholders increases, particularly in the absence of a "unanimous shareholder agreement," the duties of the directors, and the steps they should take to protect themselves, approximate those of directors of public companies. The additional risk here is that directors might mistake the object of those duties, thinking that their responsibilities are to the shareholder who nominated them, rather than to the company. While shareholders can act in their own self-interest, generally without obligation to the other shareholders, this is not the case for directors: the usual fiduciary duties attach to them. This situation may be affected by unanimous shareholder agreements, which can remove certain matters from the authority or purview of directors; but until that is the case, directors should conduct themselves in accordance with public-company responsibility levels.
There can often also be confusion about legal representation in these situations. It is important to clarify who acts, without conflict or doubt, for the directors (particularly the independent directors). Inhouse and the company's customary external counsel may have management or substantial shareholder loyalties. Various family shareholders, and their nominee directors, may have their own counsel. Great care is required to ensure that the company-first responsibilities of the directors are being properly represented.
(iii) Crown Entities
Crown entities also tend to have one shareholder. But the purposes of Crown organizations, and therefore their boards, are often more complicated. Crown entities may exist to provide advice to governments, to exercise authority on somewhat of an independent basis, or to isolate a governmental function from political pressures.
Directors of Crown entities tend to be subject to the usual duties of care and strict duties with respect to the avoidance of conflicts. Whether or not directors' and officers' insurance is obtained, directors of these entities typically have indemnification from highly creditworthy organizations for acts taken in their capacity as directors and in good faith, minimizing their financial risk exposure.
However, the role of directors of Crown entities tends to be distinctive, and their exposure follows. A key factor in the Crown environment is that policy tends to originate outside of the board, with the shareholder. This is comparable to what happens in private companies, although in private companies the owner tends to be a director participating directly in the development or delivery of policy. The board of a Crown entity must be aware of the extent to which it can influence policy, either generally or in the course of its implementation.
The board must also be aware of the political dynamic involved, in two ways. First, there may well be a value associated with the board process – particularly within a highly participatory model – so that access and involvement by third parties, such as publicinterest groups, may be valued even to the point of impairment of board efficiency. Second, the very reason for the establishment of a Crown entity may lead to the abandonment of directors in a situation where the entity experiences an unhappy event. All of us can probably think of situations in which the chair of the board or all of the directors are fired after some wrongdoing is uncovered (and, typically, broadly publicized). The government will often attempt to portray the situation as one in which bad directors have been relieved. The directors may well portray it as a situation in which the directors operated within the policy guidance they were given, and with apparent government support, which was withdrawn as soon as adverse implications could be drawn. Issues at Ontario's hydro authorities, at the Niagara Parks Commission, and at the City of Toronto's public housing authority illustrate both views.
The possibility of being "thrown under the bus" is the ultimate risk (and, sometimes, the ultimate badge of honour!) in a situation in which reputational risk is the real exposure.
- Directors of a Crown entity must recognize the risk of abandonment and deal with it by assiduous concern for appearances of conflict and a recognition that the director might ultimately find him – or herself alone, apart from the shareholder and from other directors.
- Directors must try to fulfil their duties even though a sole shareholder does have ultimate authority.
- Particular care should be taken to ensure that appropriate comments and concerns are made on and recorded in the formal records, even at some risk to collegiality.
(iv) Charitable Companies
Charitable boards are even more complicated. Board processes here involve the usual fiduciary duties, and potential liabilities must be addressed with indemnification and insurance as elsewhere. However, charitable boards tend to have participation or involvement per se as a significant aspect of the board process. Any failure by a charity also tends to excite media and public interest, so the reputational risk is highly significant.
Accordingly, the more difficult exposures here involve disappointing members or beneficiaries of the charity, and reputational risk generally. Suitable protection here may involve the following:
- As with any other boards, the charitable board's job is distinct from that of its management. This is particularly important here because charities are often much controlled by their executive team, as opposed to their boards of directors, whose membership may change frequently. Directors should insist on sufficient information and a "formal enough" process to allow the board to do its work. Despite the seeming formality and possible sense of lack of trust that may ensue, it is important for the board to do its job and for it to insist on board leadership in aid of that, as well as suitable advance material and clarity on the board's agenda.
- There must be an unusually scrupulous concern with independence, both in the sense of lack of conflicts and, because of the very strong hand of management, independence from management. Given the usually laudable purposes that motivate charities, it is easy to lose sight of other board concerns, ranging from the participatory nature of the corporation's processes through rigour in ensuring operational efficiency.
- Directors must remain acutely aware of the political dynamic that is often present in these organizations. Public companies usually have the shining star of "maximizing shareholder value" to lead them forward, albeit clouded with some concern for other interests. The guiding light in a charitable corporation is often at so lofty a level as to not provide guidance. Directors may have to evolve for themselves what the purposes of the organization are, and what policies should be preferred over or at the expense of others. These corporations often lack the benefit of a single controlling or government shareholder that can deliver policy directives, so the evolution of policy alternatives tends to be more wide open and potentially destabilizing. An awareness of this dynamic and an insistence on the evolution and observance of suitable processes may help to minimize the risk here.
All the Same But Different!
Despite the apparently common expression of their legal duties, directors in different types of organizations are exposed to different kinds of risks. They must protect themselves by understanding the nature of those risks, and addressing them as is appropriate to the particular environment
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.