The board of directors: rights, duties and responsibilities

The goal of this article is to provide guidance to bank holding companies and their boards in understanding and applying sound corporate governance practices. As a threshold matter, it is important to note that a bank's board of directors constitutes a group of persons chosen to serve the corporation by: 1) promoting constituent interests (often, but not exclusively, stockholder interests); 2) serving as the body governing the corporation's affairs; and 3) overseeing the management of the corporation.

In this role, the board provides both oversight and strategic direction to the corporation. In recent years the latter role, providing strategic direction, although essential to a business's long-term success, has often been neglected in favor of enhanced oversight functions in the current internal control-driven business climate.

The strategic direction function generally involves formulating corporate policy and strategic goals with management and taking actions with respect to specific matters. The oversight function concerns ongoing monitoring of the corporation's business and affairs. Such function includes attention to the following: corporate business performance; plans and strategies; risk assessment and management; compliance with legal obligations and corporate policies; and the quality of financial and other reports to the corporation's constituencies.

This includes attention to matters suggesting a need for inquiry or investigation. In pursuit of both the strategic direction and oversight functions, directors have, individually and collectively, various duties, responsibilities and rights.

What does it mean to be a director?

As a body, a board has considerable power. In contrast, an individual director, acting alone, has almost no power or authority. Nonetheless, the individual director is legally accountable for his or her own actions and for corporate actions in certain circumstances, and has legally protected rights and duties (and corresponding obligations) to participate in the board's decisions on an informed basis.

Effective performance of a board's oversight function often results from an individual director's recognition that a particular matter of concern warrants inquiry or action. It is important to recognize that judgment is exercised on an individual basis and that informed judgment depends upon individual preparation and participation, as well as group deliberation.

The role of the board is to direct the business and affairs of the corporation. The implementation of the board's directives is delegated to and carried out by the officers, employees and agents of the corporation. The board adopts appropriate policies and procedures (i.e., internal controls) to ensure effective oversight of these officers, employees and agents. The responsibility for all major corporate decisions ultimately rests with the board.

What are the rights, responsibilities and duties of a board?

Under most states' laws, directors have the fundamental responsibility of directing the management of their corporation's business and affairs. In exercising this responsibility, the directors owe certain fiduciary dudes to the corporation and its stockholders (and, in certain circumstances, other parties). The duties of care, loyalty and good faith are common terms for the standards that guide all actions a director takes.

The duty of care requires that directors act in good faith, with the level of care that an ordinarily prudent person would exercise in similar circumstances, and in a manner that they reasonably believe is in the best interests of the corporation. Stated another way, the duty of care requires directors to acquire sufficient knowledge of the material facts related to the proposed transaction, thoroughly examine all information available to them with a critical eye and actively participate in the decision-making process.

In fulfilling this duty, unless there is reason to believe that the information provided is untrustworthy, a director may rely on the records of the corporation and such other information, opinions, reports or statements prepared or presented by: corporate officers or employees; outside experts retained by the corporation (e.g., legal counsel, public accountants); and information provided by a committee of die board.

In most instances, the standard for determining whether a director has breached the duty of care is one of gross negligence, which means reckless indifference to, or a deliberate disregard of, the stockholders, or that the actions are "without the grounds of reason."

The duty of loyalty requires mat directors exercise their powers in the interest of the corporation and its stockholders radier dian in the director's own self-interest or in the interest of any other person. Directors taking action on a particular matter must be independent, meaning they can consider the transaction on its merits free from any extraneous influences. The duty of loyalty primarily relates to corporate opportunity, confidentiality and conflicts of interest.

A clear expression of the duty of good faith as a separate and distinct duty emerged on June 8, 2006, with the Delaware Supreme Court decision in the case of In re The Walt Disney Company Derivative Litigation. This duty was formerly viewed as a subset of the duty of care, although commentators had long speculated on its impending emergence as a distinct fiduciary duty.

A breach of the duty of good faith generally (but not exclusively) involves an intentional dereliction of duty or a conscious disregard for one's responsibilities as a director. A violation of the duty of good faith is properly treated as both nonexculpable and non-indemnifiable by the corporation. In spite of good faith's ascension, whether that duty is one that, like the duties of care and loyalty, may serve as an independent basis for imposing liability upon officers and directors, has yet to be determined by the courts.

What standards apply in evaluating a board's discharge of its duties?

Under the business judgment rule, a court will presume that directors have made decisions on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the corporation. This presumption offers directors strong protection because the court essentially declines to second-guess their decisions.

However, the protections of this rule are only available in those cases where the directors have satisfied their duties of care, loyalty, and good faith. The protections of this rule will not be available in cases where 1) a majority of the directors stand on both sides of the transaction (even when the transaction is approved by a majority of the disinterested directors); or 2) a controlling stockholder of the corporation is on both sides of the transaction (even though the transaction is approved by a majority of the disinterested directors and/or stockholders).

These cases are generally subject to the "entire fairness" standard. The business judgment rule will also not be available in "sale of control" transactions or transactions that include deal protection devices. Such transactions are generally subject to the "enhanced scrutiny" standard.

What are the board's risk mitigation tools?

Liability of directors for their actions on behalf of the corporation may be limited by statute, by the corporation's organizational documents, or by contract. A director should carefully review the indemnification rights afforded by the corporation, including understanding under which circumstances a director must, may, or may not be indemnified.

A director should also consider the financial wherewithal of the corporation to make good on indemnification obligations if they become due, and the director's priority in relation to other potential claimants against the financial resources of the corporation under likely indemnification scenarios.

Although indemnification generally provides strong protection for directors, it is strongly recommended that corporations also purchase and maintain director and officer insurance. Under most state corporate laws, a corporation may purchase and maintain insurance on behalf of a person who is or was a director of the corporation. As with indemnity provisions, the director should carefully review the policy inclusions and exclusions, claim limits, who may make claims against such limits and in what priority and to what effect claims by other potentially covered parties could affect availability of coverage for the director.

An often overlooked director risk mitigation technique is for a director to affirmatively vote against bad board decisions (abstaining from the vote is not enough) and ensure that the director's negative vote is recorded in the board minutes. In the event that a board-approved action is ever challenged, a director who dissented (voted against) such action will generally not be subject to liability if such board action is later found to have been improper.

As discussed above, directors must always put the interests of the corporation before their direct and indirect personal and professional interests. Because of the makeup of many bank boards (comprised of significant stockholders, business owners, providers of professional services, etc.) potential conflicts of interest are almost certain to arise from time to time. There is nothing inherently wrong with a potential conflict of interest, but the board must be sure to follow the framework provided by applicable laws when faced with a potential conflict of interest. For that reason, the board should establish and adhere to a written conflicts of interest policy.

Many bank holding companies have developed active and comprehensive compliance programs tailored to their particular circumstances, through which such corporations implement and monitor internal control programs and processes.

Several of the most common internal control features include: establishing standing audit, nomination and compensation committees containing independent directors (and a "financial expert" for the audit committee); adoption of a written audit and financial practices policy; adoption of a conflicts of interest policy; adoption of a records retention and destruction policy; adoption of codes of conduct and ethics; adoption of a whistleblower protection policy; and instituting procedures to insure that codes of conduct and policies are diligently employed.

In a bank holding company, the directors' principal constituents are the stockholders. The directors understand that their primary function is to advance the stockholders' wealth, and it is the stockholders, in most instances, who may call the directors to account.

However, as circumstances change, the constituencies of the bank holding company may also include such groups as employees, account holders, contracting parties, the communities served by the bank, and others. Directors should be mindful of how their decisions could impact constituencies other than just stockholders, and should monitor the business press to keep abreast of emerging trends in the type of claims being filed against directors and boards.

Conclusion

So what messages should a director take away from this article? Adhere to your fiduciary duties. Take solace in the protection the business judgment rule affords the actions of the board. But consider and utilize the additional risk mitigation techniques described above. And most importantly, act in good faith by not consciously and intentionally disregarding your duties.

[Author Affiliation]

William Quick is a shareholder in the Kansas City office ofhlsmelli Shalton Wette Suelthaus P.C. He can be reached at 816-360-4335 or wquick@pswslmv.com.