I have not spent much time in this blog on the “corporate” side of the in-house world. Over the next few posts, I will discuss some key issues regarding basic corporate law. If this is an area you focus on already, you have it down, but for many in-house lawyers whose practice focuses on litigation, IP, employment, or other areas it’s not something you see every day. If you hope to sit in the general counsel chair one day, it’s important to have a solid understanding of several basic areas of corporate law.
Underlying most everything in corporate law is what I call “basic corporate governance.” This includes the formation of the corporation, operation of the Board of Directors (the “Board”), delegation of authority, annual compliance issues, and so on. This edition of Ten Things will discuss basic issues regarding corporate governance. While the below is fairly USA-centric — as the details of corporate law vary widely by jurisdiction — I will include some reference material for corporate governance issues outside the USA toward the end:
1. Formation. There are several different legal entities you can utilize to operate your business, such as a sole-proprietorship (i.e., run by an individual), a partnership, or a limited liability company (LLC). Professional groups (accountants, law firms) often utilize a special entity designed just for them, e.g., a “professional limited liability company” or “PLLC.” The favored business entity in the USA is a “for-profit” corporation (we’ll skip “not-for-profit” corporations for this post). A corporation is in essence a separate legal “person” (but is not a “natural person”) and has the ability to own property, to sue and be sued, enter into contracts, make political donations, and a host of other attributes. A corporation can be “privately” held (its shares are not generally available to the public) or “publicly” held (its shares are listed/traded on a public exchange, such as the NYSE or NASDAQ). There are three things that make corporations a preferred entity for business: 1) the shareholders are protected from liability for the debts and actions of the corporation, 2) corporations have perpetual life (i.e., they don’t “die”), and 3) they operate according to set rules, meaning investors have assurances around key aspects of how the company will operate and how their investment in it will be protected.
In the USA, the “rules” regarding how a corporation is formed and operates are governed by the state where you incorporate. State law governs things like the duties of the Board, shareholder rights, annual filing requirements, issuance of stock, and mergers. The most popular state for incorporation is Delaware because it has a well-developed body of law regarding corporations (generally favorable to the company/Board), business friendly statutes, sophisticated courts with respected judges, ease of filing annual or required documents, and investors typically expect it.
2. Key documents. There are several core documents every corporation will have in place:
- Articles of Incorporation – sometimes called the “charter” or “certificate.” This document is the primary governance document of the corporation and is filed with the state of incorporation. It sets out the name of the corporation, the number and types/classes of stock issued, the registered agent (i.e., the person who accepts notices, lawsuits, etc. on behalf of the corporation), the names and addresses of the incorporators, and other things required by the state law. Incorporators usually try to prepare the least detailed articles with the broadest powers possible, e.g. that the corporation may engage in any lawful purpose or endeavor (even if the company starts out making shovels). This allows the business to grow and expand in ways not foreseen at inception. The articles of incorporation can only be amended by vote of the shareholders.
- By-Laws– set out the detailed rules for running the corporation on a day-to-day basis. They are secondary to the articles of incorporation, meaning in the event of a conflict the articles control. They contain such things the size of the Board, its committees, the process for holding meetings (including voting by email or allowing telephonic meetings). They contain provisions to resolve conflicts of interest and may contain provisions designed to ward off unwanted solicitations or takeovers (i.e., “poison pills”). By-laws do not need to be filed with the state and can be amended by the Board, making them superior to the articles in terms of flexibility for the corporation.
- Shareholder’s agreement – these are very common in privately held corporations and set out the relationship and rights between shareholders, for example what happens to the stock of shareholder when they die. These agreements protect minority shareholder rights and ensure the corporation can function in the event of dysfunction between the shareholders.
3. Who’s Who? There are several important players in operating a corporation:
- Shareholders – these are the “owners” of the corporation and own the shares of stock issued by the company. They vote on key issues, such as mergers and the members of the Board. Shareholders can range from owners of a few shares to large “institutional” shareholders (like billion dollar pension funds) that own large percentages of the stock of a corporation. The more shares you own the greater your influence.
- Board of Directors – the Directors work for the shareholders and their job is to oversee the running of the corporation by the company’s officers and employees. For small companies, the Directors may also be owners and officers and heavily involved in the business. For large companies the Directors delegate day-to-day responsibility to management.
- Officers – most state laws require a corporation to have several officers, including a President, Treasurer, and Secretary. In Delaware all that is required is a President and Secretary. Any other officers are simply those created by the company for its own purposes, e.g. the general counsel, CFO, CIO, and so forth. Officers are usually approved by the Board and have titles like Executive Vice President or Senior Vice President (though you have to be careful of the apparent authority bestowed on any employee based on their title).
- Advisory Board– many corporations have advisory boards made up of experts on certain areas of the company’s business or who have other desired expertise. Their role is to give non-binding advice as requested by the business. An advisory board is not the same thing as the board of directors and is not subject to the same governance standards and other duties.
4. Duties of the Board of Directors. The Board members have a number of duties they owe to the shareholders of the company. First, they need to regularly attend and actively participate in the meetings of the Board and any committees they are assigned to. Typical committees include Audit, Compensation, and Governance. There can be a committee for just about any purpose. Many large corporations have Executive committees (that can make decisions when the full Board is not available) and Technology committees (dealing with cyber-risk). Directors are usually paid for their work, a combination of cash per meeting and equity in the company.
Directors make decisions on material issues facing the company, e.g., a merger or a stock offering. In doing do, they owe the company/shareholders a duty of care (to act with the care that an ordinarily prudent and careful person would use in similar circumstances) and a duty of loyalty (to act in good faith for the benefit of the corporation and its shareholders – not for their own interests). Directors are usually immune to legal liability under the “business judgment rule” which states that so long as a majority of the Directors have no conflicting interest in the decision, their decision will not later be second-guessed by a court if it is undertaken with due care and in good faith. The business judgment rule applies even if the business decision later turns out to have been a bad decision. Most corporations provide for the indemnification of their Directors and Officers directly in the by-laws and through the purchase of Director and Officer (D&O) insurance.
5. Delegation of Authority. The owners of the corporation, the shareholders, are the ultimate authority. Unless the corporation is very small the shareholders cannot effectively make day-to-day decisions. Authority is usually delegated from the shareholders to the Board via the articles of incorporation and the by-laws (with some decisions reserved for shareholder approval). The Board is usually not in a position to be involved in every day-to-day decision either and, in turn, delegates the authority for many actions to the CEO/President of the corporation. The CEO has the ability to delegate authority down to his/her direct reports (i.e., the other officers of the company who handle the various staff groups and lines of business). Additional delegations run all the way down to the lowest levels of the company hierarchy. As in-house counsel, one important task you have is to be familiar with the delegations of authority for your company (which may be a rather complex document) and understand who does – and does not – have authority to take certain actions or make certain decisions. You do not want a situation where you are about to sign a contract or close a transaction only to find out that you do not have a person present authorized to make the decision or sign the document. Lastly, keep in mind that any powers not specifically delegated by the Board are reserved to the Board. For example, if the CEO/President can authorize an acquisition worth less than $10M, then only the Board can approve an acquisition worth more than $10M.
6. Resolutions/Minutes. One important task of a corporation is to ensure proper records are kept of its actions. This is done either through resolutions or the minutes of Board or committee meetings. A resolution is formal written document that sets forth an action of the Board and records the vote. Most resolutions are voted on during meetings (in person or telephonic). In some instances the by-laws permit electronic voting via email. The record of what occurred during a Board meeting is called the “minutes” of the meeting. The minutes, resolutions, and other key corporate documents (e.g., the articles of incorporation, by-laws, stock ledger, etc.) are kept in a “minute book.” Keeping an up-to-date and accurate minute book is very important, especially in the event of a transaction involving the sale of your company or in the event actions of the Board are challenged. This also means that the proper drafting of corporate meeting minutes is very important (especially in these litigious times). Minutes are not a verbatim transcript of what was said at each meeting. Instead, they should focus on things like:
- The meeting date, time and location.
- The nature of the meeting (regular, committee, special, telephonic, etc.)
- A list of all attendees (and a list of directors absent from the meeting and whether a quorum of directors is present).
- The general topics of discussion, the names of all individuals making specific presentations and the general nature of their presentations.
- Attach the meeting agenda and reference any materials distributed before or at the meeting.
- Confirmation of all actions taken by the Board, e.g., adoption of resolutions and the vote tally.
7. Publicly Traded Companies. Corporations decide to go public for many reasons, including the ability to raise large amounts of capital and the cachet of being listed on a public exchange. While there are many benefits to being publicly traded there are a lot of additional responsibilities and potential pitfalls as well. Here are some of the key ones:
- Basic reporting. A public company must register its shares pursuant US securities laws. Once properly registered and available for sale, a public company (unlike a private company) faces a litany of disclosure obligations under the Securities Exchange Act of 1934, all with the aim of giving investors complete and non-misleading information about the company’s financial state and any risks investors face if they buy shares. Key reports are:
- 10Q – quarterly unaudited financials and other information (e.g., risk, legal proceedings, management discussion of the business)
- 10K – annual audited financials and other information (more detailed than 10Q)
- 8K – filed whenever there is a material development with the corporation. The purpose is to disseminate important information about the company to all investors at the same time. An 8K covers the time periods between the 10Q’s and the 10K. There is a long list of “triggering” events such as an acquisition of another company, resignation of an officer of the company, entering into a material contract (or loss of such a contract), release of earnings reports, etc. Public companies typically have processes in place and “disclosure committees” to evaluate when a company event requires an 8K disclosure, which must be filed within a short time of when the event occurred.
- Proxy – a document given to shareholders prior to the annual meeting that informs them of the business to be taken up at the meeting (e.g., election of directors), solicits a “proxy” for their votes, provides background and compensation information about the Board and key members of management, sets out the financial performance of the corporation, etc. The proxy is governed by Regulation and Schedule 14 of the Exchange Act.
- Forms 3 & 4 – a Form 3 is filed when a person in senior management or the Board first receives equity from the company. A Form 4 is filed when there is a change in that equity, either a sale of stock or the grant of additional equity.
- Other Issues. There is a long list of other statutory and regulatory requirements and other issues that public companies must deal with. The cost and administrative burden of complying or dealing with all of the disclosure and other issues is a major reason why some companies do not enter (or drop out of) the public markets:
- Sarbanes-Oxley – passed after the Enron, et al. scandals, the Sarbanes-Oxley Act imposed a number of new reporting and other requirements on public companies. The key is that the CEO and CFO are now required to certify (subject to criminal liability) that the statements and financials in the public filings are accurate and that adequate controls are in place at the company to ensure accuracy – which drives a lot of work within the company. Sections 302 (certification) and 404 (internal controls report) are probably the most important sections.
- Regulation FD – a requirement that companies provide “fair disclosure” of material company information and that they do not selectively disclose such information to a chosen few such as large institutional investors or analysts. It’s designed to give all investors equal and timely information. In today’s world, things like Tweets or Facebook posts can trigger Reg FD issues.
- Proxy advisory services – these are companies that advise shareholders (especially large institutional shareholders) how to vote on proxy issues. In the USA, two firms are the leading advisors: ISS and Glass Lewis. A third, Manifest, focuses on European votes. These services have become controversial regarding their ratings and other methods (e.g., companies need to pay large subscription fees to get access to the services’ rating criteria), and the SEC is looking at new regulation.
- Activist shareholders – these are investors who buy a large amount of stock in a public company for the purpose of replacing the Board or forcing management to make changes or pursue objectives favored by the activist (e.g., sale of a subsidiary, a merger). It is not clear whether, over the long-term, such investors are good or bad for companies.
8. Failure to keep up corporate “niceties.” The Corporate Secretary has a key role at a corporation. Among his/her many tasks (which include the operational aspects of the Board) is to ensure that the company makes all of the required yearly filings (state and federal), holds the annual meeting, properly records all stock transfers, pays any required fees (in the state of incorporation and any state where the corporation does business). Companies must file annual reports and pay certain fees to retain their status as a corporation. If they fail to do so, they can lose their corporate status and be prohibited from using the state’s court system or worse (for smaller companies) be treated as a sole-proprietorship or partnership which means the loss of limited liability protection for the shareholders. There can also be damage done regarding exposure to taxes, the ability to merge or create subsidiaries, get insurance, get a loan, and other consequences if the company loses its corporation status. While many states provide generous opportunities to come into compliance, you do not want to be in a situation where you are scrambling to reinstitute the corporation — and explaining to the CEO/Board why there are problems with your deal.
9. Subsidiaries, “sister” companies, holding companies. Many corporations set up subsidiaries to conduct business in different countries or in different product lines. One big reason is tax structure. Another reason is to make the subsidiary the publicly traded company while the parent remains private. Likewise, a parent company can limit exposure to itself through the use of subsidiaries, sister companies (i.e., companies that share the same corporate parent) or holding companies (companies that do nothing other than own other companies). Regardless the reason or the structure, all of the same requirements around basic corporate governance apply to subsidiary and sister corporations, which can be especially challenging if the subsidiary is partially publicly traded and there are disagreements as to what is best for all the shareholders vs. the parent corporation).
10. Resources. Here are a few resources discussing basic corporate governance that I have found particularly useful:
- The Public Company Handbook, 5th Ed.
- The Society of Corporate Secretaries & Governance Professionals
- The Importance and Elements of Delegation of Authority
- Preparing Corporate Minutes: Time Well Spent
- Corporate Governance 2.0
- Fiduciary Duties of the Board of Directors – The Basics
- Getting the Deal Through – Corporate Governance (multiple jurisdictions)
- United Kingdom, Canada, India, Singapore
- Practical Law
As you can imagine, you can do little more than hit the highlights of corporate governance in a blog post like this (e.g., I have left out state securities (“Blue Sky”) laws). Hopefully, you now have a better understanding of the basics and some places to go for additional information. As you develop your career as an in-house counsel it’s important to always be curious about other areas of the law, especially areas that go to the fundamentals of how your company operates. Look for ways to flesh out your skills. You do not have to become an expert. Being conversant and knowing the basics can go a long way even if it’s just knowing when to spot and issue and ask someone for help.
April 18, 2016
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