Summary of Major Corporate Governance Principles and Best Practices
These best practices are divided into:
Structure of the board of directors
Operation of the board of directors
Other corporate governance practices
A) STRUCTURE OF THE BOARD OF DIRECTORS
BEST PRACTICE
Governing bodies of all organizations (whether designated as boards of directors, boards of trustees or otherwise, hereafter called "boards of directors")
should include completely independent directors and these directors should preferably constitute a majority of all directors, with the possible exception of privately held companies.
BEST PRACTICE
Select independent directors who are willing and able to devote the necessary time to their director duties and preferably persons who have competencies that assist the organization and that complement the competencies of other directors.
BEST PRACTICE
Directors must have their own information pipeline into the company, separate from the information provided to them by management and the independent auditors, in order to fulfill their state law fiduciary duties. An internal auditor reporting to the board of directors or its audit committee can fulfill this function.
BEST PRACTICE
Except in the case of a private company unless there is a lead or presiding director, the chairman of the board should be an independent director and independent directors should meet separately from management directors at least once a year. If the chairman of the board is not an independent director, a lead or presiding director who is independent should be appointed.
BEST PRACTICE
Directors of all organizations must establish audit committees, compensation committees, and, in appropriate cases, nominating/corporate governance committees composed entirely of independent directors or, alternatively, must perform the duties of such committees acting through the whole board of directors, which should consist of a majority of completely independent directors. All important committees of the board of directors should evaluate their own activities annually.
BEST PRACTICE
The audit committee must include persons who have the ability and willingness to fully understand the organization's accounting, and they must, at a minimum, hire and determine the compensation of the independent auditor, preapprove all auditing and nonauditing services performed by the independent auditor, and assure themselves of the independence of the auditing firm. The audit committee is responsible for overseeing the organization's financial reporting process and should understand and be familiar with the organization's system of internal controls. For additional responsibilities of public company audit committees, see Chapters 11 through 16.
BEST PRACTICE
All organizations (with the possible exception of small private companies) should have an internal auditor, hired and compensated by the audit committee of the board of directors and reporting directly to the board of directors. The primary responsibility of the internal auditor should be to assist the board of
directors to perform its fiduciary duty to monitor management. Other operational duties may be assigned to the internal auditor by management, but these other duties should not interfere with the primary responsibility of the internal auditor. Internal auditing services may be outsourced.
BEST PRACTICE
The compensation committee must, at a minimum, establish the compensation of the top officers of the organization, use the internal auditor to verify that the compensation given to the top officers is consistent with what the committee authorized, and, either alone or together with a separate nominating/corporate governance committee, must determine that the compensation policies of the organization are consistent with an ethical, law-abiding culture (see Chapter 6).
BEST PRACTICE
Boards of directors should be kept to a reasonable size, since large boards of directors tend to be ineffective.
BEST PRACTICE
An organization should obtain a fairness opinion from a qualified and independent third party in the event of any material transaction involving a potential conflict of interest, such as an insider loan, purchase or sale, or a material merger or acquisition. Investment bankers and other qualified third parties rendering fairness opinions should not receive a percentage of the transaction consideration for rendering the fairness opinion.
BEST PRACTICE FOR PUBLIC COMPANIES
Public companies should establish an effective procedure for shareholders to communicate with the board or one of its committees, such as the nominating/corporate governance committee.
BEST PRACTICE FOR PUBLIC COMPANIES
Board compensation should include incentives to the directors to focus on long-term shareholder value as part of director compensation, and, therefore, a meaningful portion of director compensation should be in the form of long-term equity. Directors should be required to hold a meaningful amount of the public company's stock as long as they are on the board.
B) OPERATION OF THE BOARD OF DIRECTORS
BEST PRACTICE
Boards of directors should confine their activities to overseeing the management of the organization and should not engage in day-to-day management activities or in micromanagement.
BEST PRACTICE
Although directors can engage in constructive criticism, ask tough questions of management at board meetings, and disagree with each other, the discussions should be kept collegial with a view to developing a consensus.
BEST PRACTICE
Directors must determine what information they need from management to properly monitor management's performance.
BEST PRACTICE
Directors should develop metrics to monitor the performance of management and review such metrics from time to time to determine their efficacy.
BEST PRACTICE
Directors must take the time to fully consider important matters to the organization and establish a record of due diligence. In transactions in which there are potential conflicts of interest, a special committee composed of completely independent directors should be formed. These special committees must establish a complete record of due diligence in order for their decisions to be respected by the courts.
BEST PRACTICE
Directors must either directly or through committees identify the major risks of an organization, prioritize those risks, and establish internal controls and a compliance program to help ameliorate such risks. The major risk analysis should be used to develop a committee structure within the board of directors, with each committee having an oversight role with respect to each major risk.
BEST PRACTICE
The board must establish a succession plan for the chief executive officer.
BEST PRACTICE
The board is responsible for obtaining an annual operating plan from management, including annual budgets, and monitoring the performance of the annual operating plan.
BEST PRACTICE
The board has a responsibility for making certain that the organization has a long-term strategic plan and overseeing the implementation of such strategic plan by management.
BEST PRACTICE
The board of directors and the chief executive officer should have a clear understanding of the types of decisions that can be made by management without board approval and those which require board approval.
BEST PRACTICE
When conducting internal investigations that may involve top management or may be potentially embarrassing to the organization or top management, such investigations must be conducted by an independent board committee (typically the audit committee) and completely independent counsel should be used.
BEST PRACTICE
When the organization is in the "vicinity of insolvency," directors should seek the advice of counsel to assist them in performing their potential fiduciary duties to creditors.
BEST PRACTICE
Directors should not authorize personal loans or other personal extensions of credit to management or directors of private or not-for-profit organizations, or to management or directors of public companies not subject to Sarbanes-Oxley, except in the most compelling circumstances and only with arm's-length terms and documentation.
C) OTHER CORPORATE GOVERNANCE PRACTICES
BEST PRACTICE
Corporate culture is the key to corporate governance. The key to corporate culture is leadership from the top and a compensation system that rewards not only financial performance but provides positive and negative incentives to employees to report legal risks and wrongdoing up the ladder. All organizations
should adopt a law compliance and ethics policy that states the policies and values of the organization and should effectively enforce such policy.
BEST PRACTICE
A whistleblower policy should be established for all organizations (except to the extent prohibited by certain foreign laws) since, according to a 2004 survey by the Association of Certified Fraud Examiners, fraud is detected 40 percent of the time by tips (see Chapter 4).
BEST PRACTICE
All organization should have an emergency operations plan, in case of fire, flood, explosion, and the like.
BEST PRACTICE
All organizations should adopt a press and media policy that sets forth the titles of the one or possibly two individuals who have the authority to speak for the organization. Any spokesperson for the organization must be properly trained for that role.
BEST PRACTICE FOR PUBLIC COMPANIES
Public companies should adopt a by-law that provides that if a majority of the shareholders actually voting withhold their votes for a particular director, such director will not be elected.
STATE LAW FIDUCIARY DUTIES
The American Law Institute Principles of Corporate Governance characterizes the statement that follows as the "black letter law" consistent with the duty of care standards articulated in most jurisdictions today:
§ 4.01 Duty of Care of Directors and Officers; the Business Judgment Rule
a. A director or officer has a duty to the corporation to perform the director's or officer's functions in good faith, in a manner that he or she
reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. This subsection (a) is subject to the provisions of subsection (c) (the business judgment rule) where applicable.
1. The duty in subsection (a) includes the obligation to make, or cause to be made, an inquiry when, but only when, the circumstances would alert a reasonable director or officer to the need therefor. The extent of such inquiry shall be such as the director or officer reasonably believes to be necessary.
2. In performing any of his or her functions (including oversight functions), a director or officer is entitled to rely on materials and persons in accordance with §§ 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board).
b. Except as otherwise provided by statute or by a standard of the corporation … and subject to the board's ultimate responsibility for oversight, in performing its functions (including oversight functions), the board may delegate, formally or informally by course of conduct, any function (including the function of identifying matters requiring the attention of the board) to committees of the board or to directors, officers, employees, experts, or other persons; a director may rely on such committees and persons in fulfilling the duty under this Section with respect to any delegated function if the reliance is in accordance with §§ 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board).
c. A director or officer who makes a business judgment in good faith fulfills the duty under this Section if the director or officer:
3. is not interested … in the subject of the business judgment;
4. is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and
5. rationally believes that the business judgment is in the best interests of the corporation.
d. A person challenging the conduct of a director or officer under this Section has the burden of proving a breach of the duty of care, including the inapplicability of the provisions as to the fulfillment of duty under subsection (b) or (c), and, in a damage action, the burden of proving that the breach was the legal cause of damage suffered by the corporation. [12]
FIDUCIARY DUTIES UNDER DELAWARE LAW
Under Delaware law, fiduciary duties can be divided into these categories:
A duty of care (which can be modified by the certificate of incorporation), which includes various other duties including a duty to supervise and a duty to stay informed
A duty of loyalty, which has several subsets, including:
o A duty to act in good faith
o A duty of candor
o A duty to stay informed
o A duty to avoid conflicts of interest
o A possible duty to avoid entrenchment
FEDERAL LAW
Federal statutes can also affect the duties of directors and officers and create potential civil or criminal liability for directors. Federal (and state)
environmental statutes are one example. Another example is federal securities laws. If a public company is liable under the federal securities laws for material misstatements or omissions in documents filed with the Securities and Exchange Commission (SEC), directors of that public company may also be liable if:
The director is considered to be in control of the public company.
The director signed the document filed with the SEC.
In either case, they failed to establish a personal due diligence defense.
The U.S. Department of Justice Sentencing Guidelines, discussed in Chapter 4, govern situations in which an organization will be indicted for violating a federal law. These guidelines dictate the corporate governance culture that the governing body of every organization must seek to develop.
NEW YORK STOCK EXCHANGE CORPORATE GOVERNANCE RULES
The corporate governance rules of the New York Stock Exchange should serve as a model for all organizations, whether public, private, or not-for-profit.
The Nasdaq Stock Market corporate governance rules are not as strict as the rules of the New York Stock Exchange.
Best Practices to Monitor Risk in Different Organizational Departments
This chapter summarizes best practices to monitor risk within these departments or units of an organization:
Human resources (HR)
Sales
Purchasing
Insurance
Tax
Legal
Corporate development
BEST PRACTICE
The organization should periodically employ an attorney to provide an overall review of the practices within each of the departments or units of the organization to determine if best practices are being followed.
A) HUMAN RESOURCES
BEST PRACTICE
Maintain employee liability insurance in an amount adequate to protect the organization against claims, have such policy reviewed by an attorney
specializing in this area, and require the insurer to permit the organization to use its regular counsel to defend claims.
BEST PRACTICE
Provide to each employee a handbook of organizational policies that has been reviewed by an attorney and is signed by the employee.
BEST PRACTICE
Each employee should execute an employee agreement that, at a minimum, should spell out the employee's salary and benefits, the fact that the employee can be terminated at any time for any reason, the employee's duty of confidentiality, the employee's duty to assign ideas and inventions to the organization, and any nonsolicitation of customer provisions (or noncompete provisions) that will be applicable after termination of employment.
BEST PRACTICE
Establish and maintain, on an ongoing basis, a supervisory and employee training program that would include topics such as legal compliance, ethics, antiharassment (sexual and other forms), litigation avoidance, and, where appropriate, union avoidance.
BEST PRACTICE
If there is an intention to terminate an employee, written records of warnings to the employee must be maintained, an attorney should be consulted on the
overall strategy, and the employee should be given time to correct the conduct that will serve as a basis for the termination.
BEST PRACTICE
An attorney specializing in labor and employment law should review the status of all so-called independent contractors working for the organization, to determine that these individuals are really independent contractors and not employees.
BEST PRACTICE
Top management must have periodic meetings with employees to inculcate a law-abiding corporate culture.
BEST PRACTICE
All organizations should publish an employee complaint procedure that is easily accessible for all employees. The complaint procedure must contain provisions for confidentiality and against retaliation. All whistleblowers should be treated with respect and their allegations investigated. The investigation must be conducted by an independent attorney if the allegations may involve misconduct by top management or may affect the financial statements of the organization.
BEST PRACTICE
The HR department should immediately notify the board of directors of the identity of any children of directors or officers who become employed by the organization, their compensation, and any change in their compensation.
BEST PRACTICE
To avoid the problem of backdating stock option grants, have the board or its compensation or stock option plan committee grant authority to the chief executive officer (CEO) or the HR department head, within certain parameters, to grant stock options to new hires.
BEST PRACTICE
Do background checks as well as alcohol and drug testing on all new hires.
BEST PRACTICE
Prior to hiring any former partner, principal, shareholder, or professional employee of the auditing firm, obtain an opinion as to whether such hiring will affect the independence of the auditor.
BEST PRACTICE
Confirm that HR is complying with all applicable federal, state, and local laws including, but not limited to:
Fair Labor Standards Act (minimum wage, overtime classifications, child labor, I-9's [immigration], record keeping)
Employee Retirement Income Security Act (ERISA) (Are blackouts employed, properly managed, etc.?)
Uniformed Services Employment and Reemployment Rights Act (applies to veterans)
Title VII (prohibition on discrimination based on race, sex, national origin, religion)
Age Discrimination In Employment Act
Americans with Disabilities Act
B) SALES
BEST PRACTICE
Have an attorney familiar with revenue recognition policies review all form sales contracts. An attorney should also review how sales contracts are formed.
BEST PRACTICE
Customers must be advised in writing who in the organization has the authority to modify sales contracts or enter into side letters, preferably by inserting such provisions into the terms of the sales contract.
BEST PRACTICE
Return policies, if any, should be set forth in the sales contract and must be adhered to.
BEST PRACTICE
To avoid the so-called bill and hold abuse, which results in improper revenue recognition, there should be periodic review of bills to determine if the inventory has been shipped.
BEST PRACTICE
To avoid the so-called channel stuffing abuse and similar manipulations, which results in improper revenue recognition, major customers should be contacted periodically to determine whether they have actually purchased the shipped inventory.
BEST PRACTICE
Internal audit should annually review the expense reports of all sales personnel to determine if they are engaged in improper or illegal sales activities, including commercial bribery or other illegal activities (e.g., use of prostitutes).
BEST PRACTICE
No member of the sales department should be permitted to sign an audit confirmation from a third party. Any audit confirmation must be signed by the internal auditor or chief corporate governance officer.
C) PURCHASING
BEST PRACTICE
An attorney should review the terms of purchase orders.
BEST PRACTICE
Use overriding agreements with suppliers.
BEST PRACTICE
If overriding agreements cannot be consummated with all major suppliers, an attorney should review the procedures for forming contracts to ascertain that the purchasing department's terms will prevail in a battle of the forms. In the battle of the forms, the first offer typically wins. Having the purchasing department utilize request for quotation forms that contain the organization's purchase terms will assist in winning the battle of the forms.
BEST PRACTICE
If overriding agreements cannot be consummated with all major suppliers, an attorney should review the procedures for forming contracts to ascertain that the purchasing department's terms will prevail in a battle of the forms. In the battle of the forms, the first offer typically wins. Having the purchasing department utilize request for quotation forms that contain the organization's purchase terms will assist in winning the battle of the forms.
D) INSURANCE
BEST PRACTICE
Only deal with insurance agents who maintain an errors and omission (E&O) insurance policy for the agency with sufficient coverage, and require the E&O carrier to give the organization notice of any changes in the E&O policy.
BEST PRACTICE
The amount of business interruption insurance to be carried by the organization and risk covered should be carefully reviewed by the board of directors.
BEST PRACTICE
In order to attract independent directors, the organization should maintain a director and officer liability policy with adequate coverage that should not be disclaimable by the insurer at least as to innocent independent directors.
BEST PRACTICE
Directors should review with the insurance department what insurance coverages are available that the organization has elected not to purchase, including any endorsements that broaden coverage and that the organization elected not to purchase.
BEST PRACTICE
An attorney and insurance consultant should periodically review the adequacy of the organization's insurance coverage and the adequacy of the documentation needed to support a claim.
E) TAX
BEST PRACTICE
The tax administration department should identify all high-risk areas to the audit committee, particularly the use of tax shelters and tax practices that are likely to be challenged by the IRS.
BEST PRACTICE
State and local tax issues should be carefully reviewed by an attorney or an accountant who specializes in this area.
F) LEGAL
BEST PRACTICE
Major legal risks of the organization should be prioritized and methods of preventing or mitigating such risks developed proactively.
BEST PRACTICE
The board of directors or its audit or compliance committee must be informed immediately of any major new legal risks or significant lawsuits.
BEST PRACTICE
The legal department must review, on a periodic basis, the standard terms and conditions of purchases and sales and how contracts are formed by the purchasing and sales department.
BEST PRACTICE
The legal department must be kept informed of all new marketing efforts, so that it can determine the legal risks and methods of mitigating those risks.
BEST PRACTICE
The legal department should develop a record retention policy customized to the business of the organization, which should include a requirement to consult
with the legal department prior to any document destruction.
BEST PRACTICE
Intellectual property assets of the organization (trade secrets, patents, trademarks, service marks, copyrights, logos, licenses, etc.) should be
identified, classified, and protected.
G) CORPORATE DEVELOPMENT
BEST PRACTICE
All letters of intent used in connection with corporate acquisitions, whether intended to be legally binding or not, should be reviewed by an attorney.
BEST PRACTICE
Background checks must be performed on all principals and important executives of significant target acquisitions, preferably using private detective agencies.
For more Information
* Due Diligence, Corporate Governance Best Practices, Corporate Governance Books. Accountable Organization. Improve Board Performance and Accountability*
These best practices are divided into:
Structure of the board of directors
Operation of the board of directors
Other corporate governance practices
A) STRUCTURE OF THE BOARD OF DIRECTORS
BEST PRACTICE
Governing bodies of all organizations (whether designated as boards of directors, boards of trustees or otherwise, hereafter called "boards of directors")
should include completely independent directors and these directors should preferably constitute a majority of all directors, with the possible exception of privately held companies.
BEST PRACTICE
Select independent directors who are willing and able to devote the necessary time to their director duties and preferably persons who have competencies that assist the organization and that complement the competencies of other directors.
BEST PRACTICE
Directors must have their own information pipeline into the company, separate from the information provided to them by management and the independent auditors, in order to fulfill their state law fiduciary duties. An internal auditor reporting to the board of directors or its audit committee can fulfill this function.
BEST PRACTICE
Except in the case of a private company unless there is a lead or presiding director, the chairman of the board should be an independent director and independent directors should meet separately from management directors at least once a year. If the chairman of the board is not an independent director, a lead or presiding director who is independent should be appointed.
BEST PRACTICE
Directors of all organizations must establish audit committees, compensation committees, and, in appropriate cases, nominating/corporate governance committees composed entirely of independent directors or, alternatively, must perform the duties of such committees acting through the whole board of directors, which should consist of a majority of completely independent directors. All important committees of the board of directors should evaluate their own activities annually.
BEST PRACTICE
The audit committee must include persons who have the ability and willingness to fully understand the organization's accounting, and they must, at a minimum, hire and determine the compensation of the independent auditor, preapprove all auditing and nonauditing services performed by the independent auditor, and assure themselves of the independence of the auditing firm. The audit committee is responsible for overseeing the organization's financial reporting process and should understand and be familiar with the organization's system of internal controls. For additional responsibilities of public company audit committees, see Chapters 11 through 16.
BEST PRACTICE
All organizations (with the possible exception of small private companies) should have an internal auditor, hired and compensated by the audit committee of the board of directors and reporting directly to the board of directors. The primary responsibility of the internal auditor should be to assist the board of
directors to perform its fiduciary duty to monitor management. Other operational duties may be assigned to the internal auditor by management, but these other duties should not interfere with the primary responsibility of the internal auditor. Internal auditing services may be outsourced.
BEST PRACTICE
The compensation committee must, at a minimum, establish the compensation of the top officers of the organization, use the internal auditor to verify that the compensation given to the top officers is consistent with what the committee authorized, and, either alone or together with a separate nominating/corporate governance committee, must determine that the compensation policies of the organization are consistent with an ethical, law-abiding culture (see Chapter 6).
BEST PRACTICE
Boards of directors should be kept to a reasonable size, since large boards of directors tend to be ineffective.
BEST PRACTICE
An organization should obtain a fairness opinion from a qualified and independent third party in the event of any material transaction involving a potential conflict of interest, such as an insider loan, purchase or sale, or a material merger or acquisition. Investment bankers and other qualified third parties rendering fairness opinions should not receive a percentage of the transaction consideration for rendering the fairness opinion.
BEST PRACTICE FOR PUBLIC COMPANIES
Public companies should establish an effective procedure for shareholders to communicate with the board or one of its committees, such as the nominating/corporate governance committee.
BEST PRACTICE FOR PUBLIC COMPANIES
Board compensation should include incentives to the directors to focus on long-term shareholder value as part of director compensation, and, therefore, a meaningful portion of director compensation should be in the form of long-term equity. Directors should be required to hold a meaningful amount of the public company's stock as long as they are on the board.
B) OPERATION OF THE BOARD OF DIRECTORS
BEST PRACTICE
Boards of directors should confine their activities to overseeing the management of the organization and should not engage in day-to-day management activities or in micromanagement.
BEST PRACTICE
Although directors can engage in constructive criticism, ask tough questions of management at board meetings, and disagree with each other, the discussions should be kept collegial with a view to developing a consensus.
BEST PRACTICE
Directors must determine what information they need from management to properly monitor management's performance.
BEST PRACTICE
Directors should develop metrics to monitor the performance of management and review such metrics from time to time to determine their efficacy.
BEST PRACTICE
Directors must take the time to fully consider important matters to the organization and establish a record of due diligence. In transactions in which there are potential conflicts of interest, a special committee composed of completely independent directors should be formed. These special committees must establish a complete record of due diligence in order for their decisions to be respected by the courts.
BEST PRACTICE
Directors must either directly or through committees identify the major risks of an organization, prioritize those risks, and establish internal controls and a compliance program to help ameliorate such risks. The major risk analysis should be used to develop a committee structure within the board of directors, with each committee having an oversight role with respect to each major risk.
BEST PRACTICE
The board must establish a succession plan for the chief executive officer.
BEST PRACTICE
The board is responsible for obtaining an annual operating plan from management, including annual budgets, and monitoring the performance of the annual operating plan.
BEST PRACTICE
The board has a responsibility for making certain that the organization has a long-term strategic plan and overseeing the implementation of such strategic plan by management.
BEST PRACTICE
The board of directors and the chief executive officer should have a clear understanding of the types of decisions that can be made by management without board approval and those which require board approval.
BEST PRACTICE
When conducting internal investigations that may involve top management or may be potentially embarrassing to the organization or top management, such investigations must be conducted by an independent board committee (typically the audit committee) and completely independent counsel should be used.
BEST PRACTICE
When the organization is in the "vicinity of insolvency," directors should seek the advice of counsel to assist them in performing their potential fiduciary duties to creditors.
BEST PRACTICE
Directors should not authorize personal loans or other personal extensions of credit to management or directors of private or not-for-profit organizations, or to management or directors of public companies not subject to Sarbanes-Oxley, except in the most compelling circumstances and only with arm's-length terms and documentation.
C) OTHER CORPORATE GOVERNANCE PRACTICES
BEST PRACTICE
Corporate culture is the key to corporate governance. The key to corporate culture is leadership from the top and a compensation system that rewards not only financial performance but provides positive and negative incentives to employees to report legal risks and wrongdoing up the ladder. All organizations
should adopt a law compliance and ethics policy that states the policies and values of the organization and should effectively enforce such policy.
BEST PRACTICE
A whistleblower policy should be established for all organizations (except to the extent prohibited by certain foreign laws) since, according to a 2004 survey by the Association of Certified Fraud Examiners, fraud is detected 40 percent of the time by tips (see Chapter 4).
BEST PRACTICE
All organization should have an emergency operations plan, in case of fire, flood, explosion, and the like.
BEST PRACTICE
All organizations should adopt a press and media policy that sets forth the titles of the one or possibly two individuals who have the authority to speak for the organization. Any spokesperson for the organization must be properly trained for that role.
BEST PRACTICE FOR PUBLIC COMPANIES
Public companies should adopt a by-law that provides that if a majority of the shareholders actually voting withhold their votes for a particular director, such director will not be elected.
STATE LAW FIDUCIARY DUTIES
The American Law Institute Principles of Corporate Governance characterizes the statement that follows as the "black letter law" consistent with the duty of care standards articulated in most jurisdictions today:
§ 4.01 Duty of Care of Directors and Officers; the Business Judgment Rule
a. A director or officer has a duty to the corporation to perform the director's or officer's functions in good faith, in a manner that he or she
reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. This subsection (a) is subject to the provisions of subsection (c) (the business judgment rule) where applicable.
1. The duty in subsection (a) includes the obligation to make, or cause to be made, an inquiry when, but only when, the circumstances would alert a reasonable director or officer to the need therefor. The extent of such inquiry shall be such as the director or officer reasonably believes to be necessary.
2. In performing any of his or her functions (including oversight functions), a director or officer is entitled to rely on materials and persons in accordance with §§ 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board).
b. Except as otherwise provided by statute or by a standard of the corporation … and subject to the board's ultimate responsibility for oversight, in performing its functions (including oversight functions), the board may delegate, formally or informally by course of conduct, any function (including the function of identifying matters requiring the attention of the board) to committees of the board or to directors, officers, employees, experts, or other persons; a director may rely on such committees and persons in fulfilling the duty under this Section with respect to any delegated function if the reliance is in accordance with §§ 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board).
c. A director or officer who makes a business judgment in good faith fulfills the duty under this Section if the director or officer:
3. is not interested … in the subject of the business judgment;
4. is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and
5. rationally believes that the business judgment is in the best interests of the corporation.
d. A person challenging the conduct of a director or officer under this Section has the burden of proving a breach of the duty of care, including the inapplicability of the provisions as to the fulfillment of duty under subsection (b) or (c), and, in a damage action, the burden of proving that the breach was the legal cause of damage suffered by the corporation. [12]
FIDUCIARY DUTIES UNDER DELAWARE LAW
Under Delaware law, fiduciary duties can be divided into these categories:
A duty of care (which can be modified by the certificate of incorporation), which includes various other duties including a duty to supervise and a duty to stay informed
A duty of loyalty, which has several subsets, including:
o A duty to act in good faith
o A duty of candor
o A duty to stay informed
o A duty to avoid conflicts of interest
o A possible duty to avoid entrenchment
FEDERAL LAW
Federal statutes can also affect the duties of directors and officers and create potential civil or criminal liability for directors. Federal (and state)
environmental statutes are one example. Another example is federal securities laws. If a public company is liable under the federal securities laws for material misstatements or omissions in documents filed with the Securities and Exchange Commission (SEC), directors of that public company may also be liable if:
The director is considered to be in control of the public company.
The director signed the document filed with the SEC.
In either case, they failed to establish a personal due diligence defense.
The U.S. Department of Justice Sentencing Guidelines, discussed in Chapter 4, govern situations in which an organization will be indicted for violating a federal law. These guidelines dictate the corporate governance culture that the governing body of every organization must seek to develop.
NEW YORK STOCK EXCHANGE CORPORATE GOVERNANCE RULES
The corporate governance rules of the New York Stock Exchange should serve as a model for all organizations, whether public, private, or not-for-profit.
The Nasdaq Stock Market corporate governance rules are not as strict as the rules of the New York Stock Exchange.
Best Practices to Monitor Risk in Different Organizational Departments
This chapter summarizes best practices to monitor risk within these departments or units of an organization:
Human resources (HR)
Sales
Purchasing
Insurance
Tax
Legal
Corporate development
BEST PRACTICE
The organization should periodically employ an attorney to provide an overall review of the practices within each of the departments or units of the organization to determine if best practices are being followed.
A) HUMAN RESOURCES
BEST PRACTICE
Maintain employee liability insurance in an amount adequate to protect the organization against claims, have such policy reviewed by an attorney
specializing in this area, and require the insurer to permit the organization to use its regular counsel to defend claims.
BEST PRACTICE
Provide to each employee a handbook of organizational policies that has been reviewed by an attorney and is signed by the employee.
BEST PRACTICE
Each employee should execute an employee agreement that, at a minimum, should spell out the employee's salary and benefits, the fact that the employee can be terminated at any time for any reason, the employee's duty of confidentiality, the employee's duty to assign ideas and inventions to the organization, and any nonsolicitation of customer provisions (or noncompete provisions) that will be applicable after termination of employment.
BEST PRACTICE
Establish and maintain, on an ongoing basis, a supervisory and employee training program that would include topics such as legal compliance, ethics, antiharassment (sexual and other forms), litigation avoidance, and, where appropriate, union avoidance.
BEST PRACTICE
If there is an intention to terminate an employee, written records of warnings to the employee must be maintained, an attorney should be consulted on the
overall strategy, and the employee should be given time to correct the conduct that will serve as a basis for the termination.
BEST PRACTICE
An attorney specializing in labor and employment law should review the status of all so-called independent contractors working for the organization, to determine that these individuals are really independent contractors and not employees.
BEST PRACTICE
Top management must have periodic meetings with employees to inculcate a law-abiding corporate culture.
BEST PRACTICE
All organizations should publish an employee complaint procedure that is easily accessible for all employees. The complaint procedure must contain provisions for confidentiality and against retaliation. All whistleblowers should be treated with respect and their allegations investigated. The investigation must be conducted by an independent attorney if the allegations may involve misconduct by top management or may affect the financial statements of the organization.
BEST PRACTICE
The HR department should immediately notify the board of directors of the identity of any children of directors or officers who become employed by the organization, their compensation, and any change in their compensation.
BEST PRACTICE
To avoid the problem of backdating stock option grants, have the board or its compensation or stock option plan committee grant authority to the chief executive officer (CEO) or the HR department head, within certain parameters, to grant stock options to new hires.
BEST PRACTICE
Do background checks as well as alcohol and drug testing on all new hires.
BEST PRACTICE
Prior to hiring any former partner, principal, shareholder, or professional employee of the auditing firm, obtain an opinion as to whether such hiring will affect the independence of the auditor.
BEST PRACTICE
Confirm that HR is complying with all applicable federal, state, and local laws including, but not limited to:
Fair Labor Standards Act (minimum wage, overtime classifications, child labor, I-9's [immigration], record keeping)
Employee Retirement Income Security Act (ERISA) (Are blackouts employed, properly managed, etc.?)
Uniformed Services Employment and Reemployment Rights Act (applies to veterans)
Title VII (prohibition on discrimination based on race, sex, national origin, religion)
Age Discrimination In Employment Act
Americans with Disabilities Act
B) SALES
BEST PRACTICE
Have an attorney familiar with revenue recognition policies review all form sales contracts. An attorney should also review how sales contracts are formed.
BEST PRACTICE
Customers must be advised in writing who in the organization has the authority to modify sales contracts or enter into side letters, preferably by inserting such provisions into the terms of the sales contract.
BEST PRACTICE
Return policies, if any, should be set forth in the sales contract and must be adhered to.
BEST PRACTICE
To avoid the so-called bill and hold abuse, which results in improper revenue recognition, there should be periodic review of bills to determine if the inventory has been shipped.
BEST PRACTICE
To avoid the so-called channel stuffing abuse and similar manipulations, which results in improper revenue recognition, major customers should be contacted periodically to determine whether they have actually purchased the shipped inventory.
BEST PRACTICE
Internal audit should annually review the expense reports of all sales personnel to determine if they are engaged in improper or illegal sales activities, including commercial bribery or other illegal activities (e.g., use of prostitutes).
BEST PRACTICE
No member of the sales department should be permitted to sign an audit confirmation from a third party. Any audit confirmation must be signed by the internal auditor or chief corporate governance officer.
C) PURCHASING
BEST PRACTICE
An attorney should review the terms of purchase orders.
BEST PRACTICE
Use overriding agreements with suppliers.
BEST PRACTICE
If overriding agreements cannot be consummated with all major suppliers, an attorney should review the procedures for forming contracts to ascertain that the purchasing department's terms will prevail in a battle of the forms. In the battle of the forms, the first offer typically wins. Having the purchasing department utilize request for quotation forms that contain the organization's purchase terms will assist in winning the battle of the forms.
BEST PRACTICE
If overriding agreements cannot be consummated with all major suppliers, an attorney should review the procedures for forming contracts to ascertain that the purchasing department's terms will prevail in a battle of the forms. In the battle of the forms, the first offer typically wins. Having the purchasing department utilize request for quotation forms that contain the organization's purchase terms will assist in winning the battle of the forms.
D) INSURANCE
BEST PRACTICE
Only deal with insurance agents who maintain an errors and omission (E&O) insurance policy for the agency with sufficient coverage, and require the E&O carrier to give the organization notice of any changes in the E&O policy.
BEST PRACTICE
The amount of business interruption insurance to be carried by the organization and risk covered should be carefully reviewed by the board of directors.
BEST PRACTICE
In order to attract independent directors, the organization should maintain a director and officer liability policy with adequate coverage that should not be disclaimable by the insurer at least as to innocent independent directors.
BEST PRACTICE
Directors should review with the insurance department what insurance coverages are available that the organization has elected not to purchase, including any endorsements that broaden coverage and that the organization elected not to purchase.
BEST PRACTICE
An attorney and insurance consultant should periodically review the adequacy of the organization's insurance coverage and the adequacy of the documentation needed to support a claim.
E) TAX
BEST PRACTICE
The tax administration department should identify all high-risk areas to the audit committee, particularly the use of tax shelters and tax practices that are likely to be challenged by the IRS.
BEST PRACTICE
State and local tax issues should be carefully reviewed by an attorney or an accountant who specializes in this area.
F) LEGAL
BEST PRACTICE
Major legal risks of the organization should be prioritized and methods of preventing or mitigating such risks developed proactively.
BEST PRACTICE
The board of directors or its audit or compliance committee must be informed immediately of any major new legal risks or significant lawsuits.
BEST PRACTICE
The legal department must review, on a periodic basis, the standard terms and conditions of purchases and sales and how contracts are formed by the purchasing and sales department.
BEST PRACTICE
The legal department must be kept informed of all new marketing efforts, so that it can determine the legal risks and methods of mitigating those risks.
BEST PRACTICE
The legal department should develop a record retention policy customized to the business of the organization, which should include a requirement to consult
with the legal department prior to any document destruction.
BEST PRACTICE
Intellectual property assets of the organization (trade secrets, patents, trademarks, service marks, copyrights, logos, licenses, etc.) should be
identified, classified, and protected.
G) CORPORATE DEVELOPMENT
BEST PRACTICE
All letters of intent used in connection with corporate acquisitions, whether intended to be legally binding or not, should be reviewed by an attorney.
BEST PRACTICE
Background checks must be performed on all principals and important executives of significant target acquisitions, preferably using private detective agencies.
For more Information
* Due Diligence, Corporate Governance Best Practices, Corporate Governance Books. Accountable Organization. Improve Board Performance and Accountability*
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