Good Governance: Directors and Officers
by Ronald C. Lazof

Although this topic is much in the news due either to the failure of companies to achieve responsible Good Governance or the raft of "new" high profile regulations. The obligations and duties implicit in the service to the shareholders, required by all directors and officers is neither new nor "news". This article's focus is on the duties and obligations owed by directors and officers to all stakeholders. It should be read by not only those who serve as directors and/or officers, but also those to whom directors and officers owe their duty of care, i.e. shareholders, creditors, vendors, lenders, employees, etc.

Under law, directors and officers owe a fiduciary duty of care to their shareholders. This duty is the highest duty of care and/or dealings which any individual could exhibit in the conduct of their own affairs. Law, however is not the be all and end all of an individual's obligations to society, but rather is the encodification by society of a set of rules agreed to by the body politic. Implicit in law are standards of conduct and morality. Accordingly, the thesis of this discussion will be broader than the mere requirements of law, as currently encompassed.

The standard of conduct required by law is not set by that duty performed and held by the average director or officer in the community. In other words the proliferating moral bankruptcy of corporate America, in general does not lower the standard of care required just because the mean (average) of care performed has fallen to new and previously unplumbed lows. Rather, the standard of performance set by law and required is and ought to be that level of performance which would be expected of the most intelligent, most well informed man in the community, acting not for his own account but as a trustee for the interest of others - his shareholders. This does however, not require "hindsight's" perfection in his substantive decisions. Decisions made or actions taken or omitted are and should be subject to the reasonable business judgment rule. Here the standard is not what would be done by the best, brightest, and most well-informed, but what would be done by a reasonable business man of reasonable intelligence, reasonably well-informed, with reasonable experience as determined by the community standard. However, that standard of substantive performance must be applied in an environment free from any taint, or the appearance of taint of self-interest. "Service before self" is the measure required in the discharge of a fiduciary's obligations.

The abuses which have received so much publicity, the Enrons, Worldcoms, Arthur Andersons, and Global Crossings, have occurred not only in the public sphere, but also among privately held businesses, where amorality is a rampant disease. Who is injured if a sole shareholder who also serves as the sole officer and director of a company runs his personal expenses through the corporate entity, or inflates his stated inventories (thus lowering) his reported profits and income tax payment obligations, or under-reports income or inflates expenses? Some might argue no one! A tree that falls in woods is silent if there is no one near to hear it! I disagree! Not only are the non-shareholder stakeholders, vendors, creditors, and governmental taxing and regulatory authorities - the body politic, damaged, but the individual shareholder sustains an inchoate loss. Which oft times only surfaces in a subsequent sale of the business or investor transaction and must then be explained. This of course does not speak to the moral destitution and the slippery slope that such loose and questionable conduct implicitly condones. If you cheat on your taxes, are you more likely to close your eyes to other moral failings i.e. lie to your children, or cheat on your spouse?

When preparing a business for sale, it is common to look for "Add Backs" to make the business compare favorably to other businesses in the same industry. For example, if a business owner has paid household help as a business employee with the thought of avoiding personal income taxes on the salary not taken, since this expense would be personal and therefor non-deductible, on a subsequent sale of all or part of the business, he will want to add that expense back to the profits. Since businesses often sell at a multiple of profit, or earnings before interest and taxes, EBIT, the five or ten thousand dollars ($5-10,000) in taxes saved each year, through this "harmless and victimless" device may affect the business's value for sale purposes by ten to twenty times or fifty to two hundred thousand dollars ($50 to $200,000)! Of course, the seller can try to explain this to the buyer - unofficially! But, he most probably will be required to disclose the "theft" in written form in the Purchase Agreement - thus, a written admission of a probable felony (tax fraud)!

Furthermore, the Seller has also, by implication, advised a potential business associate that he, the Seller, plays fast and loose with the truth, and is not to be trusted - even when the potential penalty is criminal in nature. Is this the kind of person a Buyer with alternative investment options is going to ignore? Probably not! At a minimum, he will require indemnification by the Seller for all of the known and unknown sins of the past. But what of those that are unknowable? After all the Seller has already painted himself as a liar, when it suits his purposes. Many Buyers, at this point choose prudently to walk away from the prospective transaction and all of its potential for liability and grief. After all, how ironclad can an indemnity be? What will be the cost in time and money to enforce the indemnity through lawyers and courts? With the Seller's known and admitted history it is not likely that he will "own up and pay up" without being pushed to the limit.

At a minimum, the Buyer will certainly be advised that the business is worth less because of the potential for unknown and unfavorable liabilities. And, if one Buyer is potentially so advised, then it is likely that all buyers would be so advised and therefor the market value of the business (that price at which a willing buyer and a willing seller would transact business neither being under a compulsion to do so) would be accordingly decreased when valued in comparison to a "clean' business - one without the liabilities implicit from the so-called victimless theft. But, we do not have to look to an ultimate sale or refinancing of the business to find harm to the entrepreneur; how about the immediate harm done to his business's credit rating and financial resources caused by understating true operating profits due to understated income or overstated expenses?

One of my clients is a third generation family business that has provided the extended family with all of their income for over fifty (50) years. It has become ingrained in the family members that they have a "right" to an income stream from the company by virtue of their birthright irrespective of their contribution to the enterprise. To a certain extent, in good times, this is just a reallocation of family wealth among its members and is understandable and perhaps even socially laudable. However, in economically tough times, not only is it more difficult to reduce unneeded and noncontributory expenses i.e., the salaries of family members, in make-work, no work or work assignments for which they are not skilled or educated, but merely hold by virtue of family status, but even if changes could be made for the future without disrupting the family and the ownership - the family's past actions have crippled the family members on the "dole" and denuded the business enterprises of a depth of financial resources that would otherwise have been accumulated.

Thus, in effect, the damages, of what are thought by the family to be benevolent family "gifts" and sharing can actually be two-fold: (a) to the company as the income paid out needlessly will not have been accumulated in the company to provide a cushion fo the lean times in the business cycle; and (b) to the individuals who were cushioned from reality by the family's good intentions, and consequently will not have developed marketable skills, accumulated valuable work ethic habits, or pursued educational opportunities, and will almost certainly, be eventually cast adrift in the unforgiving marketplace when the business suffers or ultimately fails.

Of course, in addition to all of this "self-injury" and potential and actual injury to the body politic, there is direct and immediate injury to the business's non-shareholder/director stake holders. Creditors, lenders, and vendors continue to extend credit and choose to do business with the company based upon financial representations made. Not only is there the direct risk associated with the financial information being incomplete or inaccurate, but there are the indirect risks of dealing with a principal who is assumed to be honest and is in fact not. How do you as a vendor choose to do business with one customer over another? How do you price your products and services? Implicit in these questions is the cost of goods and services sold, but also a premium for the risks involved (payment, collection, continuation of the enterprise) and there is here intentional misrepresentation of the business's financial health.

If we move away from the sole director, officer, shareholder, or family owned corporation to that which, while still small or closely held, has at least one other shareholder, even or especially if only a minority, one who holds less other fifty percent (50%) interest, the legal perils become more easily visible. One of my clients is a closely held (2 shareholders) successful (millions of dollars per year on profits) business where one director had a single, momentary lapse of focus with respect to his obligations and required duty of care as a director. He acted for his self-interest and with disregard for the interests of his fellow shareholder/director and officer. This single act, created upon its ultimate discovery, so much controversy and distrust that the company,or if you prefer the "golden goose", producing these extraordinary profits became impossible to manage, and is now in the process of court supervised dissolution and liquidation. Obviously, the director at fault now realizes his failing, but it was impossible to stuff the genie back in the bottle, or perhaps more appropriate "Pandora back in her box."

Of course, as is often the case when one does something of this nature, the "felony" tends to be compounded by the cover-up or secrecy which follows and surrounds the initial wrongful act which just serves to make the appearance of the act worse. The "cover-up", here, as in most cases, I believe, was caused by the fact that the director/actor in question knew at some level, at least subconsciously, at the time of the act, that it was improper - and was not something of which he would be proud. One of the directors of the company I used to manage as President and C.E.O., postulated that the best test for any contemplated action was, "would you want to see it as the headline in your hometown newspaper?" Sometimes, the knowledge does not rise like cream to the conscious surface, until after the act, but even at that late date, it might, with proper immediate and full disclosure accompanied by acknowledgment and appropriate reparations, allow for the re-establishment of some degree of trust between the parties. Thereafter, failure to disclose - "the cover-up" - becomes the Watergate, cause celebre, and even the substance of the original wrongful act becomes less of the immediate and focus of the dispute at issue.

Less obvious than the loss and damages occasioned by the act of self-dealing to the fellow shareholder are the repercussions and the losses visited by this act on the corporation's third party stakeholders. The shareholder damaged can resort to the law to recover damages experienced and may in addition be able to recover his costs and legal fees. In an exceptional case, he may even be able to recover punitive damages against the wrongdoer, if the wrongdoer has sufficient assets (a very big if). But he, like the other stakeholders will never be truly made whole - because the future profits of the now defunct business - will never be generated or realized and they are almost always too speculative for a court to determine and award as damages.

But what of the damages incurred by the other stakeholders? Employees that are now terminated and either have no jobs or at least incur the cost of re-employment or relocation. Vendors, suppliers, and lenders that no longer have a profitable company to deal with, even if paid in full for past services, etc., etc. These stakeholders have no redress at law for their lost opportunities, futures and security. But, clearly they are at least as potentially damaged as the wronged shareholder.

That the law does not provide a remedy for every wrong is axiomatic. However, that the law does not provide a remedy, does not and should not in anyway relieve a director or officer, who loses their way in a forest of self-interest from bearing at least the full measure of moral guilt and societal reprobation such a callous act of disregard deserves. Perhaps, like public and government service the best remedy is "day-lighting" the wrongful acts and doers, such that they suffer as punishment, the rightful disdain of their former peers.


Ronald C. Lazof currently serves as a managing director of Prism Advisors, LLC, a management advisory and consulting organization. Prism focuses its attention on the entrepreneurial, emerging growth and mid-sized privately held corporate markets. Mr. Lazof served as President and Chief Executive Officer of Behr Process Corporation from 1996 to August 2001, playing a key role in the company's move from a private family held business to a publicly held multi-plant manufacturer and distributor of paints and coatings. Contact Ronald by e-mail: rlazof@zirkel.us and visit http://www.prismadvisors.com/ .

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Copyright 2004 by Ronald C. Lazof. All rights reserved.

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