An ESOP-Owned Corporation and Its Board of Directors

This article is a review of the fundamentals of corporate governance at an ESOP-owned company and those practices which may be used to avoid a board of directors breakdown

Recent business headlines have been awash with stories of corporate fraud, misleading financial statements, mismanagement and breakdowns in corporate governance at large publicly held corporations. The President and Congress have worked together to adopt new rules for corporate responsibility. While this may seem irrelevant to ESOP-owned corporations, similar problems can easily arise at an ESOP-owned company where its board of directors is not functioning properly. This has, in fact, happened repeatedly, as the court casebooks will readily evidence.

What follows is a review of the fundamentals of corporate governance at an ESOP-owned company and those practices which may be used to avoid a board of directors breakdown.

Corporate governance is an umbrella term that includes specific issues arising from interactions among senior management, shareholders, the board of directors and other corporate stakeholders. Shareholders perform certain duties, while other duties are the responsibility of the board of directors and the corporate officers. These are the persons who are trusted with the safe-guarding of the shareholders’ and ESOP participants’ interests. The discussion on the following pages will focus on the role of the board of directors in an ESOP-owned company.

A board of directors seldom appears on the organizational chart of a company, yet it is the company’s ultimate decision-making body. Elected by the shareholders in accordance with their company’s Articles of Incorporation, Bylaws and ESOP provisions, they typically oversee senior management, appoint top officers, establish strategic direction, approve employee and officer compensation and decide upon significant corporate actions not required by law to be subject to a shareholder vote. Directors are held to a very high legal standard to exercise sound business judgment. This "fiduciary" status means that a director is expected to obtain adequate information about items that come before the board and to exercise his or her "business judgment" for the benefit of shareholders.

The composition of board membership and its size varies widely among companies. While many publicly held companies have large boards, employee and non-employee directors, most closely held companies have only employee directors, including founding family members and managerial employers.

The existence of an ESOP does not necessarily change the board structure, but often times where the ESOP has obtained control of a corporation, the composition of the board changes gradually to give the ESOP more direct influence on the board composition. The evolution of board membership is among the most critical aspects of sound governance.

There are several key questions which each ESOP-owned company must address sooner rather than later: What is the most appropriate structure for a board of directors of a company? How big should the board be? What proportion of the directors should be managers of the company? What proportion should be outside, non-executive directors? Should the chairman of the board also be the chief executive? Board structure is at the foundation of board activity; board membership (the abilities, affiliations and attributes of the members) provides the driving force, and board style produces the effectiveness.

At its simplest, board structure distinguishes between directors who hold management positions in the company and those who do not. Those with management positions are often referred to as "executive directors" and those without such positions as non-executive or "outside directors."

A further distinction can be drawn between non-executive directors who are generally independent of the company and those who, although not employees, are in positions that might affect their independence and objectivity. For example, they may be close relations of other board members, past executives of that company, representatives of companies in the firm’s added-value chain such as suppliers, agents, distributors or customers, or nominees of large equity shareholders or providers of legal and accounting services.

Where a company has an all-executive board, every director is also a managerial employer of the company. Many start-up, family firms and ESOP companies have this structure, where the founder, close colleagues and other family members are all working in the business as well as being members of the board. The boards of some subsidiary company operating groups also choose the all-executive board, which is, in substance, the top management team of the business with no outside members.

As companies mature, non-executive directors get appointed to boards for a number of good reasons. Sometimes, the executive directors feel the need for additional expertise, knowledge or skills to supplement their own as the company grows larger and its activities more complex. Non-executive directors can also be appointed to be nominees of those investing equity or lending money to the business, or to secure relationships with suppliers, customers or others in the added-value chain of the business. Another reason can be succession in a family firm, when shareholdings are split between branches of the family and possibly an ESOP.

A drawback of the board that is nominated by its executive directors is that they are, in effect, monitoring and supervising their own performance. One solution to this problem is for the chairman to come to a clear understanding with newly appointed executive directors as to what is expected of them. Executive directors have to wear two hats, one as the manager of a part of the business, the other as a director responsible for the governance of the company. The important thing is not to be wearing the manager’s hat in the boardroom.

Most public companies have boards with a majority of non-executive directors, but this is the exception in the closely held business world, including ESOP-owned companies. Two challenges are often thrown at outside directors: first, that they cannot know as much about the business as an executive director does, and second, that the time they can devote to the company’s affairs may not be sufficient. A fair response to the first issue is that outside directors do not need to know as much about the business as the executive directors and need only know enough to make their unique contributions. The response to the second issue is something that needs to be dealt with prior to inviting those members to join the board.

The number of members on a board can have a significant bearing on its effectiveness. This is true in part because the number of board members affects the opportunity to make an impression and too many members and meetings can become protracted. Instead of working towards consensus, divisions may arise and cabals emerge, resulting in adversarial voting. By contrast, with too few members there may be a shortage of the necessary talents, knowledge and experience.

In the family company, another set of issues can arise for directors. Initially, corporate governance is often dominated by the founder who is also chairman and chief executive officer. Inside directors are closely related to the founder and outside directors, if they exist, have usually been invited to add knowledge, skills and experience that are not otherwise available on the board. However, on succession, real problems can arise, particularly if an inheritance has split the shareholdings between family members who are still involved in management and those who are not. This can also occur where the founder sells part but not all of his interest to an ESOP.

A question arising for many ESOP companies is whether members of the board of directors should serve as ESOP trustee. Even though this may be a widespread practice, it has substantial downsides. This is because the persons acting in both capacities are inherently placed in a conflict of interest, mostly because the trustees are required among other things to monitor the performance of the board and senior management and take actions that a shareholder would be expected to take under the relevant facts. This could mean, as one court has expressed, that the trustees may have a duty to sue themselves in their roles as directors under certain circumstances. Thus, it is a good idea to minimize the overlap of directors and ESOP trustees.

The legal environment surrounding ESOP companies often times permits flexibility in their design with respect to the level of participation of ESOP trustees and participants in the governance of a corporation. This range of participation may extend from very limited impact on governance in some companies to situations in which ESOP participants vote on all issues put before the shareholders. Each company may select the appropriate participation based on its own situation as long as it meets the minimum legal requirements.

Shareholders, including the ESOP trustee, can, at best, influence corporate behavior, even though they have only limited power to wield overall governance power. Power lies with the incumbent board. The ultimate power is the right to nominate and appoint to that board.

Thus, the crucial question becomes: Who should have the power to appoint directors and by what mechanisms? A nominating committee made up of independent outside directors is the current preferred response. But even if nominating committees of independent non-executive directors are created, might they not reflect the interests of the board incumbents who nominated them and with whom they have to work, rather than the interests of the shareholders, including the ESOP?

The creation of a nominating committee begs the question: Who chooses the outside directors on the nominating committee? Might they not form a cozy nominating committee? Might they not form a cozy club of like-minded executives from other companies, perhaps with cross-directorships?

Thus, corporate governance entails far more than financial control of the company. It is about the exercise of power over the most influential entities in modern society. Future developments of corporate governance need to go way beyond discussions of board structures and governance mechanisms to focus on the proper use of corporate power. The exercise of power (governance) over ESOP companies in the future will depend upon the answers to such questions as:

• What really happens at the board level?
• What should happen?
• How is strategy formulated?
• Should the board accept the corporate direction?
• Who supervises executive performance?
• To whom is the company’s board accountable?
• To whom should it be?

For now, ESOP companies should:

• Focus on the basics of corporate governance at the board level, and
• Find a means of electing a board that is capable of establishing corporate strategies but also able to monitor management activity to assure proper operation of the company for the benefit of all company stakeholders, especially the employee-owners.

This is not an overnight project, but is at the essence of long-term company viability. It needs constant monitoring while the company grows, contracts and addresses all of the normal challenges to survival and profitability.