Helen Lee* has been asked to be a director of Wynn Energy, a publicly traded company based in Ontario that generates and sells wind power. While she’s an energy expert, Helen has never been a director on a public board. She currently holds more than $500,000 in investments in other energy companies (mostly oil) and her spouse, Paul, works for an oil company as a senior engineer. Helen managed the heating services division of a provincial government utility, and later consulted for a rival renewable energy firm before taking a sabbatical. What should Helen consider before deciding whether to serve on the board?
*This is a hypothetical scenario. Any resemblance to real persons is coincidental.
Who do you call?
Lawyers specializing in corporate governance.
What they say
There are three aspects of diligence Helen should focus on.
A public company, first of all, [is] required under securities laws to disclose all material information. Helen can read the annual information form, which describes the background of the company, its competitors, the nature of its business [and] its risk factors. She should also read the company’s management discussion and analysis to give her an idea of the financial stability of the company, and management’s view about the story behind the numbers. And, the proxy circular provides her the governance practices of the company, and its compensation to executives and some of the board committees. All this [will help] her understand the company, its material risks and its business drivers.
The second thing is to sit down with the board chair. Helen will get a flavour for how the board operates [and] the expertise of the other members. She should ask about the relationship between the board and management. How do they interact with each other? How will she fit into the board and how does the board operate? Also, she should speak to [multiple] board members to find out what their experiences have been like.
The last thing she should do is speak to the CEO, and perhaps the CFO. This will give Helen an understanding of how they see their [own] role in running the company [and] the relationship between management and the board. She should ask about customers, suppliers [and] anything to do with the operations that she doesn’t already understand. How is the board getting along? How is management? She’ll figure that out pretty quickly from these discussions and her own intuition. In any organization, the human relations factor is important.
[As for conflicts], as part of her discussions with management and the board chair, Helen should be completely upfront as to her involvement in the industry, her consulting engagements and her connections with any competitors. The worst thing that can happen is she goes on the board, the company is trying to enter into a transaction and suddenly they realize, “Wait a minute. We have an issue with one of our board members.” [For instance, let’s say] after Helen joins the board, the company decides to enter into a significant transaction with Company B (e.g., an acquisition or licensing). If Helen had an interest in Company B, it may be that Helen has an interest in that transaction … [because she could] stand to make a lot of money. [If that’s the case], Wynn Energy may need to form a Special Committee [without] Helen to evaluate and negotiate the transaction with Company B.
Under corporate law, Helen’s fiduciary duties fall into two buckets. One is the “duty of loyalty,” which requires her to act honestly and in good faith with a view to the best interests of the company. She’s got to put the company ahead of her own personal interests. The second bucket is the “duty of care.” This requires her to exercise the diligence and skill that a reasonably prudent person would exercise in comparable circumstances. She has to make a solid effort in acting as a director—inform herself of important issues and make [careful, independent] decisions. She can’t simply go along for the ride [or] make decisions because that’s what everybody else is doing.
Directors perform oversight. They set the strategic plan for the company that’s approved by the board. The CEO and executives implement that plan [and bring] any material changes back to the board to approve. The board would [also] approve executive compensation. The other thing would be approving the public disclosure of the company in their annual, interim and quarterly financials. A newer thing is risk management. It’s important for the board to understand the company’s approach to risk management and what steps they’re taking.
[The company must] disclose risk [and] any material litigation. The most likely lawsuits are shareholders suing board members and the company on the basis that their public disclosure contained a misrepresentation (e.g., overstated earnings, how they accounted for certain contracts wasn’t right, etc.). Any large company’s going to have some litigation. If it’s significant enough to put the company at risk, or if there appear to be systemic disclosure issues, [she may not want to join].
The next thing Helen would want to see is if there’s been extensive board turnover recently. Usually, that means the shareholders have issues with the board; that can be a sign of trouble. [Examples include] recent proxy battles [or] an activist investor who’s put some of [her] own board members on.
She should also ask about indemnification arrangements for board members: contractual agreements from the company to reimburse a director for any liability he or she may incur. You’re not supposed to be put out of pocket to serve on a board. Director and officer (D&O) insurance does two things: one, it reimburses the company for indemnity payments it makes to directors and officers; [two,] if the company does not indemnify the directors and officers for various reasons (including if it goes bankrupt), then the insurance will kick in. I wouldn’t join a board that didn’t have D&O [insurance].
I don’t think Helen has any conflicts to declare. If she had shares in a direct competitor, you’d have to see if her interests in that company were material. I’ve seen some companies say you can’t hold shares in a competitor unless it’s less than 2% of a publicly traded company. Helen has to be worried about anything where she has a personal interest. If her husband’s company entered into a contract with Wynn Energy, she would want to declare that conflict and recuse herself from the meeting to approve that contract. [But] oil companies and wind energies don’t tend to contract each other.
[Based on a Supreme Court of Canada precedent], the courts will defer to the business judgment of directors as long as there isn’t a conflict and directors were acting on an informed basis.
The number one way to protect yourself from liability is to satisfy your duties. In short, your duties are to act honestly, in good faith and in the best interests of the company, and to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
What you learn
Before joining a board, read up on the company and directly ask the heads of the company and board how they operate. Take note of any troubling signs in business relationships and weigh any serious lawsuits against the company. In return, be open to the company about any potential conflicts, no matter how unlikely. Make sure the company has insurance to protect board directors. Lastly, know what your precise duties will be.
by Allan Tong, a Toronto-based financial journalist.