The Function of the Board of Directors
The primary responsibility of the board is to ensure that the company is being run in accordance with the law, the company’s governing documents (like its bylaws or articles of incorporation) and the company’s business objectives and policies. While the specific manner in which this is accomplished may vary from company to company, this responsibility generally requires the board to oversee management’s efforts to implement the company’s policies on a day-to-day basis. This may include spending time on high level strategy and policy issues, meeting with other board members for periodic board meetings or committee meetings, or overseeing implementation processes on a more hands-on basis in between board meetings. All of these activities are ways that the board is able to monitor how well management is accomplishing the company’s goals. Although management is expected to run the company on a day-to-day basis and to choose the appropriate means for accomplishing the company’s objectives, the board must conduct its own independent evaluation of the proposals received from management and develop its own position on the merit of each proposed policy or business decision . Once the board receives management’s recommendations on a particular decision, it must independently evaluate the situation and the various information available on the decision and conclude what it thinks the appropriate course of action should be. In extreme cases, if the board believes that it is operating contrary to the best interests of the company, and if the board is unable to align its business goals with those of management, the board may have an obligation to intervene and remove management from power. In addition to overseeing management, the board is also responsible for setting broad company policies. These policies provide the framework for the company’s daily operations, even though management is responsible for specifics. Generally, the shareholders of a company do not directly manage the company. As a result, the shareholders are left instead with the task of electing the board members and providing their general directions for corporate policy. The board then sets forth the means of effecting those policies on a day-to-day basis. By maintaining oversight over the management of the company and maintaining broad control over the company’s policies, the board helps to ensure that management is not operating in a manner that is inconsistent with the best interests of the company and is implementing policies that reflect the goals of the company’s shareholders.
Legal Prerequisites of a Board Member
Bylaw and statutory requirements summarize the basic requirements for board members. Because the state laws that govern corporations include membership rights and responsibilities, these guidelines must be adhered to if individuals are to serve legally on the board. For example, Age, Residence and the Absence of Conflicts of Interest are basic prerequisites to board membership.
Age. The minimum age for corporate membership is often set at 18 years. Corporate bylaws may require that members be a certain age, or older. Individuals below this minimum age generally may not legally serve on a board of directors. Most states do not set a maximum age limit. However, many corporations will require that board members be under a certain age, such as 70 or 75. Older directors sometimes find it difficult to participate in strategic planning and to be aware of new management techniques and innovative technologies. It is difficult to define the precise point at which a board member should step down, but that point should be one that falls within the range of the ages established by the company’s bylaws. Laws governing pension plans and employment practices have imposed certain conditions on board membership. For instance, some pension plans limit directorships to individuals over 21 years of age, or provide that future service will be forfeited if an individual does not reach the eligible age prior to his or her retirement.
Residence. Corporate laws vary widely with respect to residency requirements for directors and officers. Some state statutes require that the director be domiciled in the state where the company is incorporated. For example, Delaware law requires that the majority of directors be stockholders of the corporation. Some states require a meeting of directors and officers. Usually, though, residence tends to be more of a practical matter than a legal one. Almost any corporation wants its board members to be within reasonable driving distance of its corporate headquarters.
Conflicts. The issue of conflicts of interest is one with which boards wrestle constantly. All states prohibit both directors and officers from voting on corporate transactions with which they have direct or indirect material interests. Generally, a transaction is considered to be material if either party expects it will result in a gain or loss of more than 10% of its assets, liabilities or stock value. In practice, the law prohibits a board member from serving on two boards where the corporations compete. State legislatures, in an attempt to avoid excessive directors’ liability, have attempted to limit liability by the enactment of "safe harbor" statutes.
Inclusion and Diversity Among Board Members
Increasingly, legislatures nationally and internationally are considering and implementing requirements to ensure and increase existing board diversity and inclusivity. We have previously reported on the diversity-related mandate from Nasdaq as well as proposed rules from the SEC concerning board diversity. On November 30, 2021, we reported on the initiatives taken by numerous global financial institutions urging governments to legislate for increased board diversity.
While California was the first state to pass a law (Senate Bill No. 826) mandating minimum board diversity for publicly traded companies in 2018, states, corporations and institutional investors are considering and taking action to increase the diversity of boards at a rapid pace.
On the regulatory front, in November 2022, the California Department of Financial Protection and Innovation issued final regulations that expand the mandatory board diversity requirements for publicly held corporations with principal executive offices in California. The new regulations will go into effect on January 1, 2023 and apply to all publicly held corporations with principal executive offices in California, not just those that are publicly traded.
California SB 826 (2018) will continue to require each corporation with principal executive offices in California to have the following minimum number of female directors: Further, all public companies subject to California SB 826 will be required to have a minimum number of directors from "underrepresented communities." Under the regulations, companies will be required to meet the following minimum numbers of directors from "underrepresented communities": To help ensure compliance with the new inclusivity requirement, California SB 826 (2018) authorized the California Secretary of State (Secretary) to impose fines for violations of this requirement at $100,000 per violation for a first offense, $300,000 per violation for a second consecutive noncompliant year and $300,000 per violation for subsequent noncompliant years. Also, the regulations authorize the Secretary to enforce the requirement for underrepresented communities beginning April 1, 2022, including but not limited to the imposition of a fine.
Notably, on May 15, 2022, the Ninth Circuit unsealed documents concerning a legal challenge to California SB 826 (2018) alleging, among other things, that the law is unconstitutional. This case is still pending.
On the legislative front, other states have followed California’s lead by passing or proposing laws requiring diversity (including gender diversity) for corporate boards.
In 2020, Nasdaŕ announced their board diversity mandate for companies listed on its stock exchange which requires companies listed on the Nasdaq Global Select Market (Nasdaq) to have two diverse directors by August 2022: (1) one self-identified director from an underrepresented community; and (2) an additional director who self-identifies as female. The mandate will also require Nasdaq-listed companies to publicly disclose board-level diversity statistics and explain why then-inauthentic diversity objectives are being pursued. Since then, amendments and clarifications were made to the original rule and therefore the revised rule becomes operative on August 6, 2022. Importantly, and as stated in the initial statement announcing the Nasdaq board diversity mandate, this effort was undertaken to advance its broader mandate of "equitable board representation and effective shareholder voice — are crucial for investor confidence, responsible corporate governance, board effectiveness and the success of the public financial markets." The Nasdaq Diversity Initiative serves as an excellent example of the efforts for increased board diversity and the ongoing efforts for accountability through a broader set of transparency and disclosure requirements.
Mandatory Skills and Expertise of Board Members
A board of directors needs to possess or have access to a combination of skills, expertise and industry experience to help steer the company towards its strategic goals and to bring an outside perspective to the company. The ideal board member will have a situational background or work history that is relevant to the business of the company. This often includes leadership experience at other organizations of comparable size in either the for-profit or the nonprofit sector. While not an absolute requirement, prior or current director experience is also a plus. The specific mix of skills in the areas of accounting, risk mitigation, governance, compensation, financial analysis and so on will vary among board members. It is important that the board of directors take a holistic view to the qualifications of its members in order to ensure that it is properly equipped to address the overall needs of the company. When multiple companies share overlapping directors, they should take steps to ensure that they are not sharing competitively sensitive or outside information with each other. Multiple directorships can dilute the effectiveness of a board member, so companies should also consider this when vetting potential directors.
The Size and Composition of the Board of Directors
Two important components in the composition of a board of directors are the size of the board (i.e., the number of directors) and the mix of executive and non-executive directors. Generally, but not always, the board will include an executive chairperson (normally, but not in all cases, the CEO), non-executive directors, and executive directors. It goes without saying that executive directors will be limited by the company’s policies and procedures, except in extraordinary circumstances, from using their own powers or those of their executive committees to enact a director’s decision. When determining the size and composition of the board, the board may stress the importance of having a diversity of skills and experience, and it may defer to its committees for the process of the appointment of new members. Individual members of the board also may have specific qualifications in addition to those outlined in a contestable skills matrix. Another common addition to eligibility requirements is an independence requirement, allowing corporate shareholders to nominate individuals for board membership, or an age limit. The board may adopt various procedures for appointing directors. First, a notice of the vacancy on the board will generally be posted on the company’s website, inviting nominations from the company’s shareholders. Second, after a deadline for nominations, the independent directors of the board will select the desired candidates by consensus, and they will choose which candidates should be presented to the remaining members of the board for vote. The board may assume responsibility for determining whether a candidate is independent in accordance with the company’s independence criteria. Procedures for the removal and replacement of a member of the board usually require the supermajority shareholder approval of such a change.
Ethical and Fiduciary Duties of the Directors and Officers
A Board of Directors is charged with the ethical and fiduciary responsibility to act in the best interest of the company and its shareholders. Ethical standards for board members are critical because they influence the company’s reputation and affect its future value. The Securities and Exchange Commission (SEC) provides regulatory oversight for publicly traded companies. To ensure that board members comply with these rules, the state statutes that govern corporations require boards to adopt a code of conduct for their members and for the company. This code of conduct can be useful in conflict avoidance and resolution .
The SEC requires that the following information must be disclosed in a public company’s filings:
● Any family relationship among directors or officers of the company;
● Certain transactions where the amount involved exceeds $120,000 between the company and any related person; and
● Any relationships or related transactions that are required to be disclosed, to the extent such disclosure is material.
Certain states have adopted similar rules in their own statutory provisions concerning "interested directors," such as a requirement for shareholder approval of transaction terms. State statutes or agreements may also impose fiduciary duties on a director that exceed the standards imposed by the SEC or that may be different than the gender-neutral standards.
Regulatory, Compliance and Administrative Duties of the Board
Regulatory and Compliance Obligations: Association boards must operate on a continued basis in compliance with a broad spectrum of federal, state, and local laws and regulations. Perhaps the biggest area of regulatory compliance relates to the federal Fair Housing Act ("FHA") and similar state and local fair housing laws. The FHA prohibits discrimination on the basis of familial status, race, color, sex, religion, handicap, age, and national origin. In furtherance of this obligation, associations are required to make "reasonable accommodations" (i.e., exceptions) and "reasonable modifications" (i.e., physical alterations) for disabilities. The Federal Communications Commission ("FCC") issued a Declaratory Ruling and Report regarding reasonable accommodation and reasonable modification obligations which impacts some associations. The FCC’s ruling impacts associations that impose restrictions on the installation or use of satellite dishes (sometimes called parabolic antennas). The FCC’s ruling limits the types of restrictions which are permitted and clarifies the procedural requirements which must be followed by both associations and homeowners.
Assessing the Performance of the Board
Periodic evaluation is essential in order to take stock of what is being done well and what can be done better. Boards should also consider going beyond an assessment of the board as a whole, to also look at the performance and effectiveness of the individual director.
Self-Assessment One common tool for board evaluation is self-assessment. Some companies ask the members of their boards to fill out an evaluation survey. Others have a peer review process. The advantage of an assessment by an independent committee is that the committee is likely to provide the best feedback. The best feedback is critical feedback provided in a constructive manner; less valuable feedback is either too lenient or overly harsh. A balanced and objective committee can provide input in a constructive manner.
Internal Evaluation An internal review can be accomplished in several ways. For example, by way of a survey asking board members to rate or describe external trends, challenges, committee effectiveness, teamwork, and involvement. Another technique for evaluatin9 board performance is to conduct a regular internal review with a facilitator who will work with the board members. A facilitator is not part of the board. While a facilitator may be a board member or even the CEO, that person is frequently from the outside. The facilitator meets individually with each director in order to obtain input. The facilitator may also work with a small group of directors on specific topics.
External Evaluation Another way to assess the performance and effectiveness of a board is an external evaluation. The committee may choose to invite a consultant to assist in the process. Alternatively, the board may ask the chairman or lead independent director to ask a consultant to provide the board with an assessment.
Assessing the performance of individual directors can be achieved in various ways. A simple questionnaire with checklists of specific roles can be used to rate individual performance. In addition, a mechanism for providing continuous feedback to directors may prove helpful. It is also recommended that board members evaluate themselves relative to a standard of expected behavior.
Critical feedback may be offered effectively by having peers give one another feedback during the annual board retreat. The organization should set a standard of behavior for directors. Then the board can decide, for example, that no more than five individuals per year will be invited to give feedback to other members.
A more formal assessment of an individual’s performance may be based on 360-degree feedback. That type of feedback would be collected from peers, subordinates, supervisors, corrections officers, prisoners, and others to learn how the individual director is perceived. This process of course raises confidentiality and validity concerns.
There are many processes that can be utilized to ascertain the performance and effectiveness of the director of a public company. The evaluation process can take many forms, such as surveys and facilitated workshops.
Term Limits and Elections of a Board Member
It is not uncommon for directors to choose a fixed term of two or three years. It is important, however, to check your company’s governing documents to determine the length of term for directors, as bylaws often provide such information. In the absence of such a provision, most state corporate statutes provide that directors serve one year terms, and that directors will hold office until their successors are elected and qualified. There are no statutory term limits for directors. It is becoming increasingly common to see a two term limit for directors in the bylaws, with a one term limit being recommended for officers. The term limits generally do not apply in the case of a vacancy, or to filling an officer position after a resignation.
There is no requirement that directors be elected at a particular time in any given year. However , holding annual meetings is a common practice as shareholders generally expect to elect directors during such meetings, as well as ratify auditors and take other annual actions. Often director elections are staggered over a term of years or classes of directors. It is up to the board to determine the process by which shareholders shall elect directors. For example, many companies find it more convenient and easier to seek board approval first before asking for shareholder approval of new directors to allow the newly elected director time to acclimate before shareholder approval is sought. Board approved directors may then be nominated for approval at the next annual meeting of shareholders. Even though the shareholders may elect directors at an annual meeting, that does not prevent the board from filling vacancies that arise between shareholder meetings.
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