Retirement plans are the principal institutional shareholders in the stock markets. These institutional investors believe that sound corporate governance is a key ingredient in successful companies. To maximize their returns, they look for companies with strong corporate governance structures. For these institutional investors, corporate governance can best be summarized as how the corporation's board of directors operates in relation to its shareholders, officers and other stakeholders. The principles of corporate governance are as paramount to a nonpublic corporation that is partly or entirely owned by an employee stock ownership plan (ESOP) as they are in the public sector. ESOPs, as shareholders, should share the perspective that protecting their returns means they should look for governance best practices in their sponsor companies.
We have culled over 20 principles of corporate governance from published comparisons of public company best practices. This article focuses on those principles of corporate governance that are most relevant for closely held ESOP corporations. It is intended to provide basic education for board members, corporate officers, fiduciaries, and ESOP participants regarding the fundamentals of the corporate power sharing or "governance" structure. Limited commentary on best practices is also included.
This article covers the following fundamental principles:
- The legal framework
- The role of the Board of Directors
- Selecting Board members
- The role of the President/Chief Executive Officer (President/CEO)
- The role of the Chair of the Board
- Separate CEO and Chair?
The Legal Framework
The U.S. corporate model is a system that reflects social desire for business accountability. Three major characteristics of the U.S. corporate form are:
- Ownership that is separate from management;
- Management that is led by representatives elected by the owners; and
- Management that is headed by a President/CEO, who is subject to the direction and oversight of the elected representatives.
Under state law, all of a corporation's power and authority is vested in its board of directors, except as otherwise specifically reserved to the shareholders in the articles and bylaws. The shareholders annually elect the board of directors to run the corporation. Even if not specified in the articles or bylaws, modern state corporations codes specify certain corporate transactions that require shareholder approval. These include mergers, reorganizations and liquidation of the corporation. Some ESOP participants are surprised to learn that, under most state corporations statutes, certain corporate transactions, such as issuing new shares to investors, do not always require shareholder approval. If shareholder approval is not required by state law, it is the board of directors' job.
As the shareholder of record, the ESOP trustee votes the shares of the company as any other shareholder would. In turn, the Internal Revenue Code contains a list of transactions in which the ESOP trustee must "pass through" a request for voting instructions to the ESOP participants. This list of ESOP pass-through voting events may not always match the state corporations statute's list of events that require shareholder approval. An ESOP can be written to require pass-through of voting rights to participants on all issues voted on by the trustee. This design in part replicates the proxy and voting procedures of public companies whereby the slate of director candidates (and other issues the board asks approval for) are presented to the company shareholders. Note that even if the ESOP's voting rights are passed through to the participants, the ESOP trustee(s) will be required to vote the shares that are not directed by the participants. The ESOP trustee must also override the participants' directions if they are clearly not in the participants' best interests.
State corporate law recognizes that a board does not generally exercise its power and authority directly. Instead, the board exercises its authority by delegating to others who are "under the direction" of the board, such as:
- Committees of the board;
- Officers or senior management; and
- Professionals or other experts, including legal counsel and public accountants.
State law permits the board, and individual directors, to rely on information, opinions, reports, or statements, including financial statements and other financial data, that are prepared or presented by those committees, officers or senior management, and professionals or other experts.
Some state corporations statutes, the California Corporations Code, for example, provide little specific guidance on the role of officers. Instead, it is implied by the statute that officers carry out the direction of the board and manage the business and affairs of the enterprise subject to oversight of the board.
Directors exercise their authority only as a board and not as individuals. Authority is exercised only by action of a majority of the directors present at a meeting at which a quorum is present, unless the act of a greater number is required by the articles or bylaws. A majority of all of the authorized number of directors is necessary to constitute a quorum for a meeting.
Directors' business decisions are protected by the "business judgment rule." The business judgment rule applies to any situation in which directors make a decision which, in retrospect, was, or is argued to be, a bad one. If the directors are sued because of that decision, a court applying the business judgment rule will not second-guess the merits of the decision as long as the court finds all of the following to be true:
- The directors made a business decision (the rule does not apply to acts of directors which do not constitute business decisions);
- The directors exercised "due care" (this means acting like an ordinarily prudent person would act);
- The directors acted in good faith; and
- The directors did not abuse their discretion.
Note, however, that most state corporations codes provide a different standard for board decisions regarding "interested director" transactions. In such cases, the board must approve the action by a majority, without the interested director voting for approval. If the transaction is approved on this basis, then the action will have the presumption of correctness under the business judgment rule. If not, then the interested director will bear the burden of proof that the transaction was sound if it is ever challenged.
None of these principles of state corporate law are changed by the fact that a corporation may have an ESOP as a shareholder. The board of directors will still govern the corporation. The board will continue to delegate operational authority to appointed officers. The ESOP simply votes as any other shareholder.
ESOP participants and beneficiaries often confuse the standards for behavior that apply to a company's board of directors with the duties and authority of an ESOP trustee. In contrast to the corporate business judgment rule, the ERISA standards of the "exclusive benefit rule" and the "prudent expert rule" govern the actions of ESOP fiduciaries in determining whether to buy, sell, vote or appraise the shares in the trust. The standards of the board in operating the corporation are governed by the business judgment rule, which only requires the judgment of an ordinarily prudent person rather than a "prudent expert."
It is possible for an action or inaction of the board of directors to constitute a fiduciary breach where an ESOP trustee also is a member of the board of directors. The ESOP fiduciary could have a duty to sue as a shareholder (directly or in a derivative capacity, as applicable) to recover damages caused by the board on which he sits on behalf of the ESOP trust that he trustees. However, the action by the board of directors of the corporation would have to fail under the business judgment rule, and constitute a breach of corporate duty.
The Role of the Board of Directors
The investment firm TIAA-CREF, in its policy statement on Corporate Governance (Policy Statement), states that the primary responsibility of the board of directors is to foster the long-term success of the corporation consistent with its responsibility to its shareholders. In this regard, the primary responsibility of the board consists of the selection of the President/CEO, review of the corporation's long-term strategy and selection of nominees for election to the board. This is a fair and succinct statement of what a board of directors must do for the corporation.
Although a key function of the board is reviewing the strategic direction of the enterprise, boards themselves often do not have the time to strategically plan the enterprise's direction. In many cases, the company officers, who are familiar with all of the nuances of the business, and its competitive advantages and disadvantages, serve as the planning arm in proposing strategic direction for the board's consideration.
Shareholders and the company's lenders and other creditors often rely on the board to oversee the actions of the officers in their management of the business. Typically, oversight is provided by requiring that reports of the enterprise's operations and financial condition be given to the board in reviewed or audited financial statements prepared by independent CPAs.
Companies often have officers with less management experience than certain board members. Mentoring is, therefore, a common dynamic. A director who has "been there and done that" can often help guide a CEO or management team that has not. It can be critical to a company's success for its board to be composed of directors with competencies and experience that the company's officers or management team do not have.
The California Corporations Code requires a minimum number of directors based upon the number of the shareholders of the corporation. In closely held companies, it is not unusual for the board of directors to be entirely comprised of officers of the corporation. This is not ideal, however, where there are shareholders who are neither directors nor officers. Even so, it is common for a board of directors to include individuals who are also trustees of the ESOP and who may also be officers and employees of the company.
It is a best practice for private ESOP companies, just like public companies, to seek outside directors to fulfill the board's role of oversight and strategic direction for the company. This can be a difficult task for private corporations. It is, however, the most significant corporate governance hurdle for a private ESOP company to cross. It is arguably the single most important change in the corporate governance structure when the time comes for the company to evolve beyond a purely "circular" corporate control structure (i.e., where all the directors are officers, who are also the shareholders and trustees of the ESOP). Most Fortune 1,000 companies include in their corporate governance documents a requirement that a majority of the board members be independent outside directors. This may not be possible for many ESOP companies, but it is a laudable goal.
Core Responsibilities of the Board of Directors
In fulfilling its obligations, the core responsibilities of the board of directors are as follows:
- Provide continuity for the organization by assuring that management succession planning is adequate.
- Provide counsel and oversight in the selection and evaluation of senior management and approve their compensation.
- Identify candidates for election to the board with, at the board's request, involvement of the CEO.
- Ensure that appropriate and requisite expertise resides within its membership as a whole, including financial literacy and expertise needed for members of the Finance and Audit Committee.
- Compensate directors for their time, efforts and capacity to assist the company in the achievement of its long-term goals.
- Align the interests of the directors with the long-term interests of shareholders through share ownership, where possible.
- Select and appoint a President/CEO to whom responsibility for the administration of the organization is delegated.
- Support the executive and review his or her performance on the basis of a specific job description, including executive relations with the board, leadership in the organization, program planning and implementation, and management of the organization and its personnel.
- Offer administrative guidance and determine whether to retain or dismiss the President/CEO.
- Govern the organization by broad policies and objectives formulated and agreed upon by the President/CEO and officers, including assigning priorities and ensuring the organization's capacity to carry out programs by continually reviewing its work.
- Acquire sufficient resources for the organization's operations and prudently finance the company's products and services adequately.
- Review and approve the company's material capital allocations and expenditures, and material transactions not in the ordinary course of business.
- Provide for fiscal accountability, approve the budget, and formulate policies related to contracts from public or private resources.
- Review and approve management's strategic plans and long-term goals.
- Review and monitor, through the Audit Committee, the company's financial controls and reporting systems.
- Review and approve the company's financial standards, policies, and plans.
- Assure that credit can be obtained as necessary for operation of the business.
- Account to the shareholders for the policies, products and services of the organization and expenditures of its funds.
- Provide counsel and oversight with respect to relations with shareholders, customers, employees and the communities in which the company operates.
- Provide counsel and oversight with respect to corporate performance, and evaluate results compared to the strategic plans and other long-range goals.
- Accept responsibility for all conditions and policies attached to new, innovative, or experimental programs.
- Review the company's ethical standards and legal compliance efforts, and assess, from time to time, the continued effectiveness of the programs established to prevent, detect, and report violations of law or company policy.
Selecting Board Members
Two issues dominate the selection of board members. First, who should be responsible for selecting candidates and recommending them to the shareholders for election? Second, where can the company find suitable, qualified candidates to serve on the board? In a closely-held corporation, both of these issues are significant.
On the first issue, most bylaws of closely-held corporations fail to clearly state a nominating structure for selecting a slate of candidates for election to the board. This nominating structure should be contained in the corporate bylaws and/or the board's governance policy (if there is a separate governance policy) and should be clearly published. Referring again to the TIAA-CREF Policy Statement as an example, it supports the primary authority of the board of directors to select nominees for election to the board.
The Policy Statement also states that it ordinarily does not support shareholder resolutions requiring that candidates for the board be nominated by shareholders. Furthermore, each director should represent all shareholders. Therefore, TIAA-CREF, as an institutional pension trust, opposes the nomination of "specific representational" directors – directors elected by, and presumably representing, a specific subset of the company's shareholders.
This is an interesting point to focus on in the context of a closely-held ESOP corporation. Discussion at ESOP conferences and in ESOP literature often takes the position that the ESOP, or the employee/participants, should be entitled to nominate and elect representative members of the board of directors. This appears contrary to best practices of corporate governance. Directors must represent all shareholders.
The notion of representative employees being elected to the board by vote of the ESOP shares is even more troublesome. Unless individual employees of the company can demonstrate a level of business sophistication and experience that warrants their service as directors, which necessarily includes supervising the management of the company, they should not serve as directors. Alternate means of involving employees in the management of the company should be developed. Employees can better affect the value of the company through organization of their job function, than they can by serving on the board. By extension, it is not reasonable to assume that ESOP participants will be qualified to recruit and nominate candidates for the board of directors from outside the corporation.
It appears, therefore, that the responsibility to identify appropriate board candidates in the case of an ESOP company should still rest with the board, or to a committee of the board. If the board is large and well developed, this could be limited to certain outside directors who are already seated on the board. As a practical matter, recruiting and selecting candidates will likely be a cooperative effort between the President/CEO of the company, the Chair of the board (if different) and other members of the board through outreach in the business community, including trade associations, referral sources or otherwise.
This conclusion leads to the resolution of the second issue. If the board or the nominating committee of the board is responsible for recruiting appropriate candidates, then it is expected that through a network of business contacts they can identify qualified candidates to serve. This, of course, may not be easy. It will be particularly difficult for ESOP companies who are looking to expand their board of directors for the first time.
Most best practices documents on corporate governance require that boards be composed of a majority of "independent" outside directors. For most private companies this is difficult. The most important consideration is that the board must have a substantial degree of independence from management. Changes in the federal securities laws and rules for the New York Stock Exchange resulting from corporate scandals call for a strict standard of independence by excluding persons who serve in a consulting or service capacity to the company from also serving on the board. This conclusion is supported by the duties in Core Responsibilities Of The Board Of Directors.
The Role of the President/CEO
The President/CEO of the corporation is responsible for the day-to-day operation of the business enterprise. The President/CEO operates as a manager, visionary, supporter of the board in administration, and critical decision maker for day-to-day decisions of the company. In most closely held corporations, a President/CEO is also the Chair of the board of directors of the company.
In an attempt to have greater accountability to the board as the elected representatives of the owners/shareholders, the role of the President/CEO has evolved so that he or she typically has full authority to hire, fire, and compensate every other officer and employee. The reasons for this evolution are twofold. First, the board can establish levels of compensation and employment responsibilities for the entire enterprise by having the board set those of the President/CEO and allowing the President/CEO to set those of the rest of the company. This assumes that the President/CEO, taking into account his or her level of compensation and responsibilities, will then set lower levels of compensation for everyone else. Second, a board can, if it wants, replace the entire management team by replacing the President/CEO with a successor, who can then hire and fire everyone else.
Functions/Responsibilities of the President/CEO
There is no standardized list of the functions and responsibilities for the position of President/CEO. The following includes the major functions typically addressed by job descriptions of a President/CEO:
- Manage Company Programs, Products or Service Delivery.
- Oversee operations of organization.
- Oversee design, marketing, promotion, delivery and quality of programs, products and services.
- Implement the company's business plan.
- Formulate policies and planning recommendations to the board.
- Decide or guide courses of action in operations by staff.
- Look to the future for change/opportunities.
- Advocate/promote organization and stakeholder change related to the organization mission.
- Support Operations and Administration of the Board.
- Ensure staff and board have sufficient and up-to-date information.
- Assist in the selection and evaluation of board members if asked by the board to do so.
- Make recommendations and support the board during orientation and self-evaluation.
- Advise the board on company operations and changes in operations and management policies.
- Support the board's evaluation of CEO.
- Interface between board and employees.
- Manage Financial, Tax, Risk and Facilities.
- Recommend yearly budget for board approval and prudently manage organization's resources within those budget guidelines according to current laws and regulations.
- Manage financial and physical resources.
- Manage Human Resources.
- Effectively manage the human resources of the organization according to authorized personnel policies and procedures that fully conform to current laws and regulations.
- Support motivation of employees in organization products/programs and operations.
- Coordinate Community and Public Relations.
- Assure the organization and its mission, programs, products and services are consistently presented in strong, positive image to relevant stakeholders.
The Role of the Chair of the Board
The Chair of the board (Chair) is responsible for the orderly operation of the board of directors. The Chair should ensure the organization of and accountability for critical director functions. The Chair will be responsible for ensuring that the agenda for the meetings is set in cooperation with the President/CEO so that all proper issues are brought before the board. Where the President/CEO and Chair are one individual, then the visionary and strategic leadership functions of the President/CEO and the Chair merge. As a result, additional pressure is brought to bear on the President/CEO of the company. In small companies, including ESOP companies, where there is no "non-executive" Chair of the board to oversee and support the President/CEO, the President/CEO function of supporting the board of directors (including strategic planning) arguably suffers in favor of the day to day managerial aspects of the company. In this regard, corporate governance and accountability to the shareholders suffers. As a practical matter, the business decisions of the officer may be blurred with the business judgment rule decisions of the board.
Functions/Responsibilities of the Chair of the Board
The Chair of the Board:
- Is a member of, and serves as the chief executive of, the board of directors.
- Provides leadership to the board of directors, which sets policy and to whom the President/CEO is accountable.
- Chairs meetings of the board after developing the agenda with the President/CEO.
- Encourages the board's role in strategic planning.
- Appoints the chairs of committees, in consultation with other board members.
- Serves ex officio (as a result of his position, but often without a vote) as a member of committees and attends their meetings when invited.
- Discusses issues confronting the organization with the President/CEO.
- Helps guide and mediate board actions with respect to organizational priorities and governance concerns.
- Reviews with the CEO any issues of concern to the board.
- Monitors financial planning and financial reports.
- Formally evaluates the performance of the President/CEO and informally evaluates the effectiveness of the board members.
- Evaluates annually the performance of the organization in achieving its mission.
- Performs other responsibilities assigned by the board.
Separate CEO and Chair?
There is a wide range of opinion in the public market regarding whether the Chair of the board and President/CEO should be different individuals. For example, The General Motors (GM) Board Guidelines state that the board should be free to make the choice of whether to separate the President/CEO role from that of the Chair "in a way that seems best for the company at a given point in time." On the other hand, the TIAA-CREF Policy Statement states that it generally does not support shareholder resolutions concerning separation of the positions of President/CEO and Chair. A separate Chair and President/CEO is not a dominant arrangement in the public market. A significant portion of the Fortune 1000 has separated the two positions, but the majority has not. The National Association of Corporate Directors (NACD) in their Director Professionalism Report accurately summarizes the benefits of separating the two offices. The NACD states the purpose of creating a non-executive Chair or board leader is not to add another layer of power, but instead to ensure organization of and accountability for the execution of critical independent director functions. Most importantly, since the Chair is typically responsible for evaluating the performance of the President/CEO and providing continuing ongoing feedback to management and may, from time to time, be called upon to lead the board in anticipating and responding to business crises, the board should consider separating these two offices.
For non-public ESOP companies this is a difficult proposition. Most ESOP companies struggle simply with the notion of obtaining competent outside directors to serve on their boards. However, to the extent that outside directors can be engaged to serve on behalf of the corporation, then the most qualified of those directors might be groomed to serve as a Chair of the board of directors. This separation of President/CEO and Chair might be looked at as a laudable long-term goal, which ultimately may free the President/CEO to properly serve his or her function knowing that an additional resource is available to help lead the corporation.
It is not unusual for some ESOP companies to have former majority shareholders stay on in board capacities either as directors or as Chair, even after all creditor relationships with the corporation or the ESOP have been extinguished and the financing for acquisition of the ESOP shares has been completely paid. As a practical matter, in some smaller corporations, this may be seen as an imposition on successor management and may have a chilling effect on management teams that aspire to "control" a corporation once it is acquired from a former owner through an ESOP acquisition. Furthermore, smaller corporations, which may be dominated by one owner/personality, may find it difficult, or impossible, to evolve to a separate President/CEO and Chair structure. It should be noted, however, that in cases where an ESOP owns all shares, the former shareholders are no longer stakeholders and can potentially serve as truly independent directors and chairmen. At some point, however, the board and President/CEO must work together to identify a successor to a former owner at the board level as well.
What to Do?
Corporate governance of private ESOP companies typically does not resemble that of public companies. Only the largest ESOP companies have historically been able to achieve structures and policies that provide objective and independent oversight to the management of the business enterprise. With renewed focus on these principles, however, it is possible to organize a board and management relationship that provides not only greater assurance to the shareholders, but potentially better business decisions. There is no "one-size-fits-all" structure that is correct for every ESOP company. Each ESOP company must evaluate its available resources and determine how to best improve and evolve as a corporate organization.