Recently, companies around the world yielded to demands from China that they remove from their list of destinations Taiwan as an independent country. They were, instead, told to refer to Taiwan as “China Taiwan” or “China Taiwan Region”.
For example, Air India has now removed all references to “Taiwan” from its official website.
Read that news here.
U.S. aviation operators held firm for a while, but many of them recently ultimately gave in. American Airlines responded with, ““Air travel is global business, and we abide by the rules in countries where we operate.”
Read the recent article on this announcement here.
Why would a company make such a choice which, on its face, appears to be so blatantly challenging, to say the least. Taiwan is, after all , an ally of the U.S. It seems that taking a stand on moral principles would be the better course of action, rather than to bow to such demands. But, there are other principles in play.
And how about Starbucks getting rid of plastic straws? And its cups are soon to follow. They say it’s about the environment, but it had better be about the company–increasing sales and reducing costs. Other companies are following suit, which makes me think it’s more about business and less about the environment.
Read about that here.
Corporate Behavior Explained
Just so we know where we are, let’s review a few fundamentals.
- Shareholders = Owners . . . they are the people who bought a company’s stock
- Directors and the Board of Directors are chosen by the Shareholders at Shareholder Meetings
- Officers and Executives (CEO, CFO, COO, etc.) who run the day-to-day operations are hired by the Board of Directors
- Officers, Directors, Executives ≠ Owners (for the most part)
A major U.S. air carrier is, then, owned by shareholders and not by the Board, Officers, or Executives. Board members (and even officers and directors) may also be Shareholders, but in most large companies, even though they may own shares, they don’t own near enough to have much of an influence on Board decisions, and when their ownership reaches a particular level (5 percent), they are required to disclose transactions in those shares.
MANAGEMENT DOES NOT OWN THE COMPANY
At any rate, the management of a company does not own the company in any significant way, and the money the company makes does not belong to the Directors, Officers, or Executives—it belongs to the Owners, the Shareholders. In addition, the Officers, Executives, and Directors owe several important duties to the company and Shareholders which often makes actions taken by the company to seem counterintuitive or even baffling. These duties include the Duty of Care and the Duty of Loyalty, and violating these duties can have serious legal consequences for a particular Officer, Director, or Executive.
DUTY OF CARE
What is the so-called Duty of Care
The Duty of Care is a rule of responsibility owed by company directors and officers requiring them to make decisions in good faith and in a reasonably prudent manner. The Duty of Care requires directors to make business decisions after taking all available information into account, and then act in a judicious manner that promotes the company’s best interests. Directors are required to exercise the utmost care in making business decisions in order to fulfill a fiduciary duty owed to the company and, ultimately, to owners (i.e., shareholders). The other main fiduciary duty is the Duty of Loyalty (discussed below).
What Exactly is the Duty of Care
Duty of Care can be summed up in the requirement that a director or officer should
- be present,
- use good and independent judgment,
- utilize expert advice and trusted information,
- refer to meeting minutes, and
- seek to stay abreast of legal developments, good governance, and best practices.
Directors and officers should also schedule and be prepared to discuss and to review budget issues, executive compensation, legal compliance, and strategic direction.
Failure to uphold the Duty of Care may result in legal action being brought against the board of directors or officer by owners (i.e., shareholders). However, the courts will not rule on whether or not a business decision was a sound one (known as the Business Judgment Rule, in which courts defer to the judgment of corporate executives). Instead, their main focus is on assessing whether the directors:
- Fulfilled their Duty of Care by acting in a reasonably prudent manner when making the decision (in the best interest of the corporation),
- Conducted an adequate degree of due diligence (otherwise known as ordinary care),
- Acted in good faith, and
- Have not wasted corporate assets or resources on overpaying for goods, property, or labor.
And Example of Duty of Care
Assume a public company, PubCo, makes a large acquisition of rival firm ABC Holdings that effectively doubles its size. The market reaction, judging by the decline in PubCo’s share price after the acquisition is announced, is that PubCo paid too much for ABC Holdings. PubCo’s management is initially very confident that the acquisition will be accretive to earnings. But a few months after the deal closes, PubCo announces that ABC’s management had been engaged in accounting fraud that grossly inflated its revenue and profitability. Despite PubCo’s management asserting that they had no inkling anything was amiss at ABC, PubCo’s shares plunge 30 percent and shareholders launch a class-action lawsuit against PubCo’s directors.
In such a situation, if the case does go to trial (most such cases are settled out-of-court), the court would not rule on whether PubCo paid too much for ABC. Rather, it would assess whether PubCo’s board of directors conducted their due diligence on ABC and acted in good faith. The fact that the directors failed to detect the accounting fraud at ABC does not necessarily constitute a breach of the Duty of Care. But if PubCo’s directors were aware of it and chose to go ahead with the acquisition anyway, this could be construed as a breach of duty.
DUTY OF LOYALTY
What is the Duty of Loyalty
It sounds almost self-explanatory, but the Duty of Loyalty is a director’s or officer’s responsibility to act at all times in the best interests of their company. The Duty of Loyalty is one of the two primary fiduciary duties required to be discharged by a company’s directors, the other being the Duty of Care (discussed above). The Duty of Loyalty requires a director to be completely loyal to the company at all times. It also imposes the responsibility to avoid possible conflicts of interest, thereby precluding a director from self-dealing or taking advantage of a corporate opportunity for personal gain. Violation of the Duty of Loyalty may expose the director to a court order to pay restitution and stiff fines.
What Constitutes a Duty of Loyalty
The Duty of Loyalty imposes a number of additional responsibilities upon directors and officers of a company. They are required to keep confidential, i.e., not disclose or otherwise make use of, any information that they come across in their official capacity as directors or officers. They also have to report all conflicts of interest, whether actual or potential, real or perceived, to the Board of Directors, and to obtain legal advice in cases where it is unclear whether or not a conflict exists. In cases where a conflict does exist, the director should be fully transparent about it and disclose all relevant information.
Duty of Loyalty Key Components
A director’s or officer’s Duty of Loyalty has three main components:
- Not usurp (take away) corporate opportunities for their own personal gain.
- Avoid having a personal interest in transactions between the corporation and another party.
- Keep the corporation’s information private.
While these may seem like onerous requirements, a director who is completely loyal to the company will have no problem in adhering to the Duty of Loyalty. But problems will arise when directors place their own interests above those of the company or have an undisclosed conflict of interest.
Duty of Loyalty Example
Assume the director of a pharmaceutical company learns in advance that one of its most promising drug candidates has failed to meet the primary endpoints of a pivotal Phase 3 trial. The press release about this negative development is scheduled to be released after market close the next day. The director immediately places an order to sell his substantial share holdings at the current market price, as the stock price is bound to slump when the news is released. By doing so, the director has used confidential information for his own enrichment, opening himself up to a lawsuit for violating the Duty of Loyalty, not to mention a criminal charge for insider trading.
BUSINESS JUDGMENT RULE—GIVING THE BENEFIT OF THE DOUBT
The Business Judgment Rule helps to guard a corporation’s board of directors and officers from frivolous allegations about the way it conducts business. Commonplace in common law countries, the rule states that boards are given the assumption that they have acted with fiduciary standards of loyalty, prudence, and care. Unless it is apparent that the board of directors has blatantly violated some major rule of conduct, the courts will not review or question its decisions or dealings.
More About the Business Judgment Rule
The Business Judgment Rule assumes that directors and officers act with a fiduciary duty in an interest to protect the company that the board or officers serve. Unless it can be proven otherwise, the benefit of the doubt is given to the board members. This is to protect board members from frivolous accusations regarding their decision making for a company. The reason for this rule is to acknowledge that the daily operation of a business can be innately risky and controversial. Therefore, the board of directors should be allowed to make decisions without fear of being prosecuted. The Business Judgment Rule further assumes that it is unfair to expect those managing a company to make perfect decisions all the time. As long as the courts believe that the board of directors acted rationally in a particular situation, no further action will be taken against them.
Example of the Business Judgment Rule
For example, XYZ Company’s board of directors is considering shutting down a particular product line. Profit margins on the product have been shrinking and the line of business is becoming extremely costly and eating revenues from other lines of business. The board feels there is better opportunity to focus on other areas of the business and that they would have the resources necessary to do so if this other product were discontinued. After much deliberation, they decide to proceed. Due to the Business Judgment Rule, they are protected from persecution by people who do not agree with their decision or who were negatively affected by it.