In 1742 the standard of “care” as distinct from the standard of “loyalty” was clear. Speaking about corporate directors, the English Lord Chancellor said, “By accepting a trust of this sort, a person is obliged to execute it with fidelity and reasonable diligence; and it is no excuse to say that they had no benefit from it, but that it was merely honorary.” In 1880, in the case of Hun v. Cary, Justice Earl interpreted “fidelity and reasonable diligence” to mean that a director “possesses at least ordinary knowledge and skill, and that he will bring them to bear in the discharge of his duties.”
An Independent Director:
- Is not financially or otherwise depending on the company’s management, controlling (dominating) shareholders, large counterparts, and competitors
- Is not a representative of the state
- Is not at the same time a member of the executive body
- Is not financially or otherwise depending on the company’s affiliated persons (owners of 20 percent or more votes, members of the Board of Directors, auditor, …)
- Does not represent consultants contracted by the company
- Has publicly declared his Independent Director status
- Receives the remuneration for his work at the Board of Directors only from the company
- Has necessary qualifications
- Works faithfully in the BoD
- Has a good reputation
- Disseminates accurate information about the company and maximally facilitates to disseminate access to information by all shareholders of the company
- Personal transactions of the director and his relatives with the company’s shares (and other financial instruments) are transparent for the company and its shareholders
- In case, if the Independent Director stops meeting the requirements of the Independent Director Status during his work at the Board of Directors, he immediately informs the company about this
- The Independent Director agrees to disseminate the information about material facts to shareholders upon their request, in case, if the company did not disseminate such information in a legally defined time period
Directors at that time agreed wholeheartedly that this relatively benign standard was appropriate. Even though they wanted everyone to understand that they served because of their particular wisdom and knowledge, they felt that they should not be held to a higher than average standard of care. They claimed that if they exercised duty of loyalty that they could not be held liable except for “gross” negligence or inattention to duty. This claim is eerily similar and has obvious parallels to the “plausible deniability” arguments that have been used to defend directors much more recently.
In the 1873 case of Railroad Co. v. Lockwood, the U.S. Supreme Court overturned the theory that directors were liable for only “gross negligence” and not for “slight negligence.” In his opinion, Justice Joseph P. Bradley concluded that “negligence” means simply “failure to bestow the care and skill which the situation demands.” Chief Justice Melville W. Fuller, in his comments, said that the “degree of care to which directors are bound is that which ordinarily prudent and diligent men would exercise under similar circumstances.”
Many directors and governance experts recently have expressed concern that directors simply will not serve if they will be held accountable to a higher standard of care. That argument isn’t a new one. It’s essentially the same as the argument put forth in the late nineteenth century, and described by Berle and Means, that the courts should be lenient in defining standards of care and in sentencing because requiring diligence of directors would prevent “gentlemen of property and means” from accepting directorships. Chief Justice Melvin W. Fuller’s opinion at that time held differently: if “gentlemen of property and means” did not propose to run the business with care, they were not acceptable directors. It’s hard not to compare the “gentlemen of property and means” of more than one hundred years ago with those who sit on today’s boards of directors.
The Narrowing of Duty of Care
During the 1900s, as businesses became increasingly large and complex, boards of directors continued to press for a narrower interpretation of duty of care. As their job got harder, instead of working harder, directors thought the standards of performance should be lowered. In 1963 the Delaware Court of Chancery, ruling in Graham v. Allis Chalmers Manufacturing Co., supported and confirmed that the boards of directors of large, complex companies were merely a policy-making entity. Unless they became aware of early warning signs of trouble, they had no legal duty to actively provide a check-and-balance mechanism by establishing a legal compliance program. In essence, this decision said that directors could assume that there was no agency problem unless it became obvious that there was one.
This opinion undoubtedly diluted duty of care standards by focusing narrowly on legal compliance rather than the broader issue of fiduciary responsibility. In 1996, however, the courts again reset duty of care standards. In a Caremark International, Inc. ruling, the Delaware Court’s Chancellor William Allen substantially reversed the Graham decision by saying directors had to “exercise a good faith judgment that the corporation’s information and reporting system is, in concept and design, adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.”
The Business Roundtable has, to its credit, developed one of the more thoughtful definitions of director independence.
Today, the general belief is that to fulfill this standard, directors must continually ask probing questions and be skeptical. The majority view is definitely trending to the standard expressed by Chief Justice Bradley that duty of care requires “the care and skill that the situation demands.” From a shareholder perspective, that is a reasonable expectation of directors. It’s also reasonable that the standard espoused by Justice Bradley 120 years ago makes good sense today.
Many directors today, however, seem to reject the argument that they really need to understand the details of a business. By their actions they say that “ordinarily diligent and prudent men” need only attend a reasonable number of board meetings, rely solely on information supplied to them by the managers they oversee, and vote with the CEO after a few minutes of discussion. In light of the current state of governance, they may want to reevaluate this view.
Incremental Improvement Falls Short
Often when CEOs and directors take small steps toward better governance, it’s hard to tell if they genuinely want to change their behavior or if they have simply realized that they must finally give a little ground. There is good reason to believe that many directors and executives only react to embarrassing disclosures, new compliance requirements, court rulings, or more stringent sentencing guidelines for negligence or fraud.
In the mid 1990s when victory over governance problems was declared, the practice of incremental improvements was labeled “governance by embarrassment.” More recently, Mike Mayo called it “just-in-time-governance” in reference to Sandy Weill and the board at Citigroup. Criticized for questionable financing for Enron and WorldCom, spinning IPO shares, and biased research, Weill decided to expense options, established a governance committee, promised to avoid hidden off-balance-sheet structures, and later refused a cash bonus ostensibly because the stock price had declined by 25 percent. The board promptly granted him new options on 1.5 million shares of stock that experts valued at $17.9 million. As proof of his reformation, he was nominated as a director of the New York Stock Exchange, a nomination that was withdrawn after howls of protest.
There are many other examples of better governance by default. In 1991, when Federal Organizational Sentencing Guidelines said that companies with compliance programs and procedures would be subject to more lenient treatment than companies without them, boards suddenly leaped on the compliance program bandwagon. When regulations required that audit committees include members with financial expertise, boards started paying considerably more attention to this important qualification. When Sarbanes-Oxley required that CEOs sign off on the accuracy of financial statements, executives began asking their subordinates for assurance that the numbers were correct. When investors complained loudly about obviously excessive executive compensation, minor adjustments and givebacks were made.
Wouldn’t such actions have been good practice in the absence of regulatory and legislative mandates, embarrassments, or threats of punishment? Obviously, regulation and legislation are needed to support better governance and higher standards. But that’s not enough. Directors must accept that they now have a larger obligation to diligently exercise duty of loyalty and duty of care because other mechanisms that ought to protect investors’ interests have been compromised.
Today, the general belief is that to fulfill the duty of care standard, directors must continually ask probing questions and be skeptical.