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Liability of Outside Directors and Corporate Governance --
A Comparative Study (Part I) I. Introduction (1) Development of the outside director system in the US It is "black letter" law in every U.S. jurisdiction that corporate directors are expected to perform their duties with the care, skill and prudence of "like persons in a like position." To manage the corporation in the long-term interests of the stockholders, board of directors and management must take into account the interests of the corporation's other stakeholders. To discharge its duties, the board of a large publicly held corporation should have a substantial degree of independence from management. Accordingly, a substantial majority of the directors of such a corporation should be outside (non-management) directors. In the United States, "outside" (non-executive or non-management) directors, at least in number, dominate the boards of public companies. In a 1998 study, an average board had two "inside" (executive) directors and nine outside directors. Corporate law needs to distinguish functions between a corporation's outside directors and its operational managers. (2) Structure of this article The purpose of this article is to make a comparative study of the role of outside directors in corporate governance between the United States and China. The article seeks to improve the general knowledge on and analyze certain specific aspects of China's corporate law. It also intends to reveal the complex structure of corporate governance in the United States. The first part of the article analyzes the liability system of outside directors in corporate governance under the American law approach. The second part introduces development of the liability system of outside directors under the Chinese law approach. This section also includes legal contours of the outside directors system under the Chinese corporate law and the author's suggestion on future development of this system in China. The article also compares and contrasts the status of outside directors under American and Chinese laws. In particular, this study highlights the urgency that Chinese companies (especially large public companies) set up the liability and protection system of outside directors to keep up with the pace of economic reforms. II. The US Approach (1) Scope of outside directors American
researchers in the field of corporate governance describe
inside and outside directors differently. The Corporate Director's
Guidebook designates directors as management or non-management.
A management director is one who is an executive officer of
the corporation or who is an employee devoting substantially
full time and attention to the affairs of the corporation,
one of its subsidiaries, or any other corporation controlling
or controlled by the corporation. As a general rule, a director
will be "viewed as independent only if he or she is a
non-management director free of any material business or professional
relationship with the corporation or its management." For the purpose of the discussion under the American law in this article, "outside" directors are those who are not affiliated with the company as officers or employees. (2) Justification of outside director to the corporate governance and legal advantages of outside directors Most people in academics and business area agree that there are legal justifications to introduce outside directors into the large public companies and that outside directors play an important role in the effective functioning of the board. Outside directors, especially those who are or have been key executives in other companies, provide valuable insights in corporate decision-making, serve as members of the important Audit Committee, and have a major role in determining the compensation for key management. Some commentators' thoughts deem the theoretical ideal of the outside directors as being a source of independent advice and expertise, and as providing a valuable oversight on management because of the fact that the "inside director has a certain amount of self-interest in everything he does." Thus, the outside director was built up as a "watchman" of the management. Advantages of outside directors were found not only in corporate governance, but also in the legal approach that courts use to analyze liabilities of those directors. To make judicial abstention more palatable, well-advised managers place approval of defensive tactics in the hands of outside directors - by composing the board with a majority of such directors, by having management directors absent themselves when the board made key decisions. Courts acceded to these approaches, stating that review is more deferential when outside directors approve such management decisions. (3) Duty of outside directors a. Duty of care Basically, the duty of care requires that directors (inside and outside) undertake certain responsibilities. A director or officer has a duty to his corporation to perform his functions in good faith, in a manner that "he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances." Duty of care is a concept developed by judges in America's case law. Outside directors have the primary role of monitoring inside directors and officers because they do not have enough time to oversight the day-to-day management of the corporation like the inside directors. In fact, nearly no jurisdiction expects directors, especially outside directors, to bear the entire burden of operating and managing a corporation. Outside directors generally rely on financial reports and other information supplied by officers, employees, outside professionals and board committees. This raises a question of whether we should apply different standards for duty of care between outside and inside directors. The phrase "in a like position under similar circumstances" in ALI "Principle of Corporate Governance" is the method of distinguishing between directors' different levels of skill or knowledge concerning the corporation. This phrase gives courts the latitude to consider any special skill or experience a director may possess. The phrase also recognizes that a director's responsibilities will vary with the size, location, and complexity of the corporation. Basically, outside directors bear the same duty of care as inside directors. Courts, however, may apply different standards on outside directors under some situations. One special situation under which outside directors will be imposed with liability is that of self-dealing by directors or other senior officers. Normally, there is no debate as to the self-enriching party. Legal recourse should exist against him. However, secondary liability shall be imposed upon those outside directors who negligently fail to detect and deter the self-enrichment of the inside directors or other senior officers because outside directors have the primary role of monitoring inside directors and officers. Here, the outside director is held to have breached his duty of care if they fail to find and stop the self-dealing - a legal cause of action against outside directors that would provide them an incentive to monitor effectively. Securities regulations impose different liabilities on inside and outside directors. Section 11(f) of Securities Act of 1933 states that persons specified in subsection (a) (including directors) shall be jointly and severally liable for their fraudulent misrepresentation. Despite that, the Acts states that the liability of outside directors shall be different and be determined by Section 21D(f) of Securities Exchange Act of 1934, which states that any "covered person" (outside director)… shall be liable for damages jointly and severally only if the trier of fact specifically determines that such covered person knowingly committed a violation of the securities laws. b. Business judgment rule The business judgment rule is an important tool that courts use to avoid scrutinizing directors' decisions. It effectively protects directors (outside and inside) from being liable to the business decisions in some situations. According to Delaware law, the business judgment rule provides a presumption that in making a decision directors were informed, acted in good faith and honestly believed that the decision was in the best interests of the corporation. Under this rule, the court will defer to the directors' decision and will not make a second-guessing about the decision. On the other hand, courts and scholars recognize a new formulation of the business judgment rule - the "Modified Rule." Courts normally apply this level of scrutiny when reviewing some actions taken by directors in implementing defensive tactics implicating control. The Modified Rule differs from the traditional business judgment rule in several respects, most important of which is that outside directors, who are presumably free from the debilitating conflicts of interest facing management directors, must now take affirmative steps to protect shareholder interests. The Modified Rule looks to outside directors, whose potential impartiality is cited as sufficient to rehabilitate management's disqualifying self-interest. Modified
Rule does not require courts to blindly defer to the judgments
of outside directors as unquestionably impartial in the system
of corporate governance, but instead allows courts to inquire
into whether these directors have played their proper procedural
role in the decision-making process. The Modified Rule thus
emerges as a valuable modification to the business judgment
rule because it provides for an intermediate level of scrutiny
between the extremes of absolute deference to and judicial
second-guessing of director decisions. "The duty of loyalty requires a fiduciary to act in the best interests of the corporation and in good faith." The duty of loyalty usually exists in circumstances where the fiduciary (director) has a conflict with the corporation, assuming that personal interest will be advanced over corporate interests. Conflicts of interest often include some form of self-dealing where the director is in a position to receive a benefit unavailable to other shareholders. Generally, in the duty of loyalty cases, the burden of proof will shift from plaintiff shareholders to defendant directors, and the court will scrutinize not only the fairness of the process but also the substance of the transaction. Moreover, directors are not afforded the protection of business judgment rule under those situations. One big problem of the outside directors is the lack of time they are allowed to spend with the company's management. Many outside directors are actually part-time directors and are not able to independently judge the merits or the reasonableness of the company's affairs. Even so, American case law follows the view that the process of approval and the terms of the transaction must be fair, with the burden of proof on the outside directors. Many states have enacted statutory provisions that deal with interested director transactions. Under the New York's statute, a corporate director (outside or inside) needs to disclose that he or she has an interest in the transaction, which is known as "conflict disclosure." While under California's approach, the "full disclosure" doctrine requires that interested director must fully disclose all the material information about the transaction that is known to such director, unless the information is already known by the directors asked to approve it. In spite of that, however, state statute will not affect court's continued application of the common-law approach and will not materially change the common law surrounding directors' duties of loyalty. d. Duty of independence Besides the traditional duties introduced above, scholars suggest that there should be another duty imposed upon outside directors: duty of independence. Take takeover, for example, outside directors cannot always be expected to be reliable doormen. Management is necessarily interested, and practically anyone except the management would do a better job in protecting shareholder's wealth. This conflict suggests that some interim approaches are appropriate in the takeover context, most important of which is the independence role played by the outside, disinterested directors. Despite the fact that the actual independence of the outside directors are always questioned by some people, the idea of duty of independence is somewhat useful in reforming the intermediate standards of review for mixed-motive corporate decisions. This new approach would help to focus judicial attention away from the exclusive care and loyalty assumptions and toward a better, balanced analysis. In recent years, companies themselves have realized the importance of independence of outside directors. In the mid 1990's, a corporate governance precept called for outside directors to offer to resign if they change (or lose) their jobs. The National Association of Corporate Directors Blue Ribbon Commission has suggested, "Boards should require that all directors submit a resignation as a matter of course upon retirement, a change in employer, or other significant change in their professional roles and responsibilities." The trend reflects the stricter requirement as to the independence of the outside directors. In all, the duty of independence provides standards for judicial review of corporate decision making in context in which shareholders interests argue for judicial care and directors should be capacitated as monitors. It provides a better means (or at least, an alternative means) in the mixed-motive cases. (4)
Protection of outside directors from their liabilities As we mentioned above, when accused of violating the duty of care, directors are protected by the business judgment rule. Based on the business judgment rule, the court will defer to the directors' decisions that will not be second-guessed by the judges. The rule therefore generally separate corporate boards from judicial second-guessing. Judges believe that they do not have the expertise, and it is not their role to make business decisions. However, directors are protected by business judgment rule only in cases of duty of care. In those cases, the burden of proof is on the plaintiff (normally dissatisfied shareholders) to prove director's negligence in performing his duty. The court normally is unwilling to step in the decision itself and will only look closely at the procedure by which the directors (outside and inside) made their decision. While in the duty of loyalty cases, interested directors have to bear the burden of proof and could not get the benefit ofthe business judgment rule. b. Directors' indemnification Indemnification is provided in statutes and corporate bylaws. It gives significant protection for directors, particularly outside directors. Delaware statute serves as a model for most modern indemnification statutes. The doctrine of indemnification is well reflected in Section 145 of the DGCL, which authorizes Delaware corporations to indemnify directors, and persons serving in such capacity for other entities at the request of the corporation. The law distinguishes between indemnification in third party actions and stockholder derivative actions. Based on that, the law also distinguishes between mandatory indemnification and permissive indemnification. In either type of suit, if the director is "successful on the merits or otherwise in defense of any action, suit or proceeding," section 145(c) requires that the corporation indemnify him. However, the indemnification statutes cannot help outside directors in two respects. First, smaller corporations could not afford to indemnify their directors. Second, indemnification statutes did not relieve a director from personal liability for a breach of duty of care, even if the director otherwise had acted in good faith. c. D&O insurance In the United States, almost every state statute authorizes a corporation to purchase and maintain some form of D&O (Directors & Officers) liability insurance. D&O insurance usually includes two parts. One part is to provide for the reimbursement to the corporation if it is required to indemnify the directors. The other indemnifies the directors directly if the corporation is unable to reimburse them under applicable indemnification provisions. The Delaware model of D&O insurance is followed by most jurisdictions. The model declares: "A corporation shall have the power to purchase and maintain insurance on behalf of any person who is or was a director…whether or not the corporation would have the power to indemnify him against such liability under this section." Despite the statutes, D&O insurance is not an omnipotent protection to outside directors. Under the US law, it is against public policy to insure a director against liability for his own intentional wrongdoing. D&O insurance policies are not obtainable for anything more serious than negligent misconduct. In this respect, it is not different from other insurance such as doctors' and lawyers' malpractice insurance. d. Liability elimination in bylaws & charters To
encourage the participation of outside directors, some state
statutes provide that company may put some liability limitations
into its bylaw or charter. Section 102(b)(7) of DGCL provides
that with some limitations, the company may put in its certificate
of incorporation a provision eliminating or limiting the personal
liability of a director to the corporation or its stockholders
for monetary damages for breach of fiduciary duty as a director.
The limitations include director's breach of duty of care
and director's acts or omission not in good faith or which
involves intentional misconduct or a knowing violation of
law. Moreover, the provision does not take effect unless accepted
by the shareholders as an amendment to the corporation's certificate
of incorporation. The Delaware approach serves as a model
for more than thirty other states. (The author is an attorney at the Hong Kong office of Freshfields Bruckhaus Deringer. References are available from the author upon request.) |