John P. Beavers
Partner, Bricker & Eckler LLP
December 2000

Expectations for members of governing boards and executive officers are increasing dramatically. Governance, compensation and compliance considerations are just some of the areas in which boards and executives have to determine what is expected of them in directing and managing organizations. Boards and executives, now more than ever, have a distinct need for information regarding their changing roles as leaders of organizations.

To fulfill these special needs, this periodic column will treat board members and executive officers as equal partners. Articles will explore areas of greatest interest to board members and executive officers of any organization doing business in the United States – both profit and nonprofit as well as taxable and tax-exempt, including: 

• Emerging businesses looking for substantial outside investment. 
• Small, privately capitalized businesses thinking about going public. 
• Family businesses graduating from having someone perform functions of CEO to having its first full-time CEO. 
• Businesses of any size, including publicly held corporations as well as established tax-exempt organizations, governed by a board or managed by executive officers separate from the owners.

One expectation for boards and executives that is rapidly changing is in governance. To have access to any source of capital from within the United States, organizations are expected to increase the number of independent members of their governing boards so that substantially more than a majority are independent. This is not only the expectation of investment bankers as a condition to initial public offerings and stock exchanges as a condition for admission to listing, but also of venture capital firms, institutional investors, and even commercial lenders as a condition for any equity or debt investment.

Changing expectations in governance have led to changing expectations regarding the role of executive officers. Except for the chief executive officer, an organization’s officers have gone from being members to being merely guests of the organization’s governing board. Independence is uniformly defined as excluding anyone who is or has been a member of senior management or who has a close family or similar relationship with such a member. More recently, institutional investors are requiring designation of a "lead" or "contact" independent director having powers equivalent to the chair of the board and even requiring separation of the board chair from the chief executive officer of the organization.

Expectations in terms of compensating board members and executive officers are changing as well. Prior to the 1980s, board members were compensated by modest fixed fees for meetings attended and executives were compensated largely by salaries and discretionary bonuses. During the 1980s, executive compensation changed so that at least half of an executive’s compensation became incentive compensation which, as a result of the computer revolution, was often formula-driven based upon certain financial measures. As stockholders complained about the perceived reduction in earnings resulting from cash outlays to pay this incentive compensation, organizations began substituting stock options for formula-driven incentive compensation. As the stock market has risen over the 1990s, institutional investors are now pressuring organizations to reduce use of stock options and return to the salary and discretionary bonus forms of compensation that existed prior to the 1980s. Tax-exempt entities are now compensating their executives with nonqualified stock options in mutual fund shares.

Organizations as well as their boards and executives continue to be found liable for not making full disclosure of information being traded upon for the benefit of insiders to the public. Local companies have recently attracted public attention due to the content of their webpages and sales literature. There have also been recent investigations by the Securities and Exchange Commission, the National Association of Securities Dealers and other regulatory bodies on disclosure to financial analysts on a selective rather than a broad basis. As a result, expectations for fair, accurate and complete public disclosure are increasing.

Boards and executives are also more responsible for assuring the organization’s compliance with applicable laws and moral standards. The Securities Act of 1933, which was adopted to cure some of the ills perceived as resulting from the Great Depression, was considered "revolutionary" because it holds directors and executive officers personally responsible for the accuracy and completeness of information made available by organizations in public offerings of their securities. In the late 1970s, Congress adopted the Foreign Corrupt Practices Action requiring boards, executives, and other controlling persons of publicly held companies to cause their organization to maintain internal accounting controls reasonably to assure the "accountability" for transactions in and dispositions of the organization’s assets. In the 1980s, Congress criminalized certain fraudulent business conduct by organizations and began subjecting the board members and executive officers to criminal penalties, including imprisonment, for the acts of the organization. Currently, the government is insisting that institutional investors for organizations have corporate compliance programs modeled on guidelines of the United States Sentencing Commission as a precautionary measure, in case an organization is found guilty of criminal felonies and certain misdemeanors under federal law.

Expectations of society, including government, on redressing perceived claims is increasingly litigious. Billion-dollar jury awards against directors of the parent corporation of U-Haul and billion-dollar settlements agreed to by directors of an investment banking firm have recently occurred. Increased criminal prosecution with FBI agents invading the corporate offices of Archer-Daniels-Midland, corporate officers of a pharmaceutical company being arraigned in handcuffs for alleged violation of federal drug laws, and directors and officers of hospitals being restrained from the premises of a hospital for alleged health care fraud also remind us that litigation is commonplace.

Board members and executive officers are now finding that, contrary to their expectations, an organization’s D&O insurance does not cover certain fraud claims or criminal charges. Officers are discovering that they do not have the protection of the business judgment rule.

Not only are board members and executive officers exposed to personal liability, but also their personal assets are exposed to substantial risk of loss.

Our next column will focus on the relationship between the governing board and the executive officers, suggesting that despite the changing expectations, the relationship should not become adversarial management except in the rare occasions when a level of due diligence greater than oversight is necessary.