The Northern Spy
The Spy does not claim professional legal expertise in the matters discussed in this column. Moreover, because laws respecting fiduciary duty may vary widely among jurisdictions, no specific reliance should be placed on the general views and principles expressed herein. Competent counsel should always be consulted before taking any actions respecting such issues, lest the remedy prove more costly than the disease.
the Spy wished one category of miscreant--the spammer--a long vacation in a cool damp place with bars on the door. This month he turns the reader's attention to yet another white collar offender, the misbehaving senior manager or director (board member).
In recent years we've been treated to a sorry parade of corporate frauds and other failures. A company puts up a brave front for a time, issuing press releases touting encouraging assays on supposed gold properties, contracts allegedly signed or under negotiation with big players in the same industry, or bumpf around hardware or software products supposedly under development and near completion--any or all of which will shortly pour millions of denarii into the coffers, enhancing the company stock and enriching those investors smart enough to get in on the ground floor, form the line to the right to hand over your money, thank you very much. No one mentions that at best this is venture capital, most of which earns no return.
Then, with the suddenness of a summer thunderstorm over the prairies, the bank accounts are empty, the products vapour, the mine a dud, the contracts illusory. Every penny the investors handed over has vanished, and the principals have gone on to other ventures leaving the much touted enterprise a shell worth little or nothing, but their own bank accounts and possessions much enhanced.
Notorious examples include the Bre-X mining failure of a few years ago, and the more recent Enron collapse, but there were many software and other high-tech failures that contributed to the dot-com bust in the early part of the last decade, and the near collapse of the banking system just a couple of years ago. We're all going to pay for both the next generation at least. How do these things continue to happen?
The short answer is that such failures are the inevitable consequence of greed, incompetence, fraud, and assorted other misbehaviours on the part of the principals, and of greed, ignorance, and wilful failure to perform due diligence on the part of their dupes. Yes, the latter ought to remember that if it looks too good to be true, it is. But the Spy cannot help wondering whether anything can be done to head off repeated organizational collapse and consequent stakeholder losses. Can't the misconduct that leads to such failures be analysed and prevented? In what follows, the Spy offers positive suggestions, a deeper analysis, and his own take on specific issues, some of which extend far beyond the monetary.
The first principle of organizational governance is
that the executive officers and board members of any entity have the absolute "duty in trust" (or "fiduciary duty") to provide sound governance for the collective benefit of all stakeholders. Someone who is a fiduciary has a duty of faithful trust and loyalty to the whole entity that encompasses its people, finances, mission, vision, values, principles, policies, and procedures. This duty takes precedence over all personal preferences, beliefs, and agendas. To put it in the negative, any action by a fiduciary affecting said entity that gives first priority to personal considerations constitutes misconduct. Note that this duty is to the entity as a whole, not to individual shareholders/members or staff/employees. It presupposes the highest possible standard of ethical performance and personal care. Legally, fiduciary duty is pervasive and originates in common law, but many statutes also codify it for specific situations.
As the Canadian Encyclopedia put it: The fiduciary duty requires that corporate directors and officers devote their undivided loyalty to the corporation. They are not permitted to appropriate for themselves corporate opportunities that properly belong to the corporation or to otherwise place themselves in a situation where their own personal interests conflict with the interests of the corporation.
One of the most common monetary frauds is the "pump and dump" where company principals salt the gold mine, arrange for reviewers of questionable virtue to tout the stock, or offer false geological or financial opinions, or to create the appearance of corporate activity where there is none. When the stock reaches lofty heights, the initial "investors" sell all their shares to gullible newcomers, who lose everything when the fraudsters leave town to enjoy their fat bank accounts until it's time to concoct the next scheme.
Other frauds involve promising high returns on investments, but only realizing these by using new money provided by a second wave of suckers to pay off the first (Ponzi scheme). Eventually the whole thing collapses, but not before the principals have evaporated vast sums of others' money.
Accompanying either or or run separately is the straightforward fraudulent looting of the organization's treasury by insiders in support of their high standard of living. Stakeholders' money ends up "invested" in luxurious yachts, private airplanes, houses, vacation properties, and gifts for mistresses.
All three of these and other frauds presuppose an utter lack of independent supervision or oversight, and in this environment may with impunity extend over years. The fraudsters line up either complaisant or complacent corporate officers and directors, who may be in on the scheme, or just convenient dupes. Unfortunately, the laws prohibiting such activities are often not well enforced, violations not well investigated, and convictions not appropriately punished. In other words, the misbehaving directors and principals are simply not held to account. As daily newspaper accounts of such antics indicate, most fraudsters are therefore multiple repeat offenders.
A fourth and more widespread kind of fraud (but related to the first) involves insider trading, wherein a fiduciary uses knowledge of the corporation derived from privileged information to predict stock movements and takes financial advantage. One often sees dramatic stock movements in the days immediately prior to a corporation making important announcements, and these are invariably due to insider trading. On conviction, the entire profits are forfeit, along with a heavy fine, and a potential jail term.
All four frauds, and other more innovative ones, are common. But what of the requirement for officers and directors to act as fiduciaries? Whatever jurisdiction (federal, provincial/state, or local) under which the organization derives its existence as a legal entity does generally codify in law the principle of fiduciary duty, even if not by specifically employing that word. Why do fiduciaries act as if these laws didn't exist? Rules? What rules?
For instance, the British Columbia Societies Act specifies: A director of a society must act honestly and in good faith and in the best interests of the society, and exercise the care, diligence and skill of a reasonably prudent person, in exercising the powers and performing the functions as a director. It also declares: A director of a society who is, directly or indirectly, interested in a proposed contract or transaction with the society must disclose fully and promptly the nature and extent of the interest to each of the other directors.
Likewise, the Canada Business Corporations Act specifies 122. (1) Every director and officer of a corporation in exercising their powers and discharging their duties shall: (a) act honestly and in good faith with a view to the best interests of the corporation; and (b) exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
Sometimes, directors and their apologists narrowly interpret fiduciary duty as a sole requirement to act to maximize the value of the company's shares. However, fiduciary duty is to the benefit of the organization, broadly stated, and this may not exactly match with maximizing share value, especially in the long term. Clauses like the ones above are broadly worded to encompass all interests that might conflict, not merely the financial. Moreover, there are also statutory and other duties to the employees, the shareholders, the law, and society as a whole, and all these must also be taken into consideration when assessing the extent of duty.
This first principle does neatly cover off the most obvious issues around financial conduct. In short, a fiduciary is prohibited from using the position to enrich or otherwise benefit him/her self, whether it be by stock manipulation (fraud), taking and using confidential information (theft) or steering business opportunities to self or friends. It also address less obvious issues. A fiduciary may likewise never use the position to advance a personal agenda, to show favouritism or to prosecute a personal vendetta against another person, whether a stakeholder or not. Doing so is a breach of trust. Moreover, the requirement to disclosure conflicts to the other directors also speaks to:
The second principle of organizational governance is
that a fiduciary may never act alone. Rather, the board of directors speaks for the entity with one voice at all times. In government, this principle is called "cabinet solidarity". Speak against a cabinet decision, and you are turfed from government. Ditto a corporate setting. That is, taking on a board position means yielding individual rights and taking on grave collective responsibilities. A person who considers the imbalance between these two is too great should decline becoming involved in such service.
This solidarity principle is an aspect of the duty of loyalty, and is sometimes misrepresented by those ignorant of such matters as requiring that directors be "yes people" to the CEO or the chair. Nothing could be farther from the truth. Indeed, sound governance absolutely requires the exact opposite--that the directors be independent of the principals and of each other, that they bring a multitude of points of view, and that they exercise due diligence in setting directions (what directors do) and in scrutinizing adherence to those directions (performance).
Every board should include at least one director familiar with financial matters (but otherwise having no monetary connection to the entity) so as to give the budget and statements proper scrutiny. In many cases, having a lawyer around the table is also advisable, to ensure there are no legal missteps. (This person must not of course, be the entity's own counsel; that would be a conflict.) A variety of others with diverse, but relevant, interests and views should be on the board so as to ensure the entity's affairs receive diligent scrutiny.
In other words, board meetings should be lively affairs, full of challenge, penetrating questions, expert opinions, vigourous discussion, and possibly considerable disagreement. Whatever a board eventually decides on a contentious matter, there is bound to be a residue of opposition. However, once a decision is taken, a mission statement or budget adopted, a financial report accepted, a president or other senior executive hired, and the meeting is adjourned, all discussion ceases at the door. Public opposition by an individual fiduciary to a board decision is an oxymoron. It also constitutes unethical misconduct.
The only exception is that a director who objects to a course of action that (s)he considers illegal or improper, may have that objection recorded in the minutes of the board meeting as a matter of public record. In such cases, if the decision does prove to be improper, the recorded dissenter escapes legal liability, but all the others (even if abstaining or absent) are liable for the consequences of the decision.
However, any director who speaks his/her opposition to some action outside the board meeting, who takes board discussions public, who criticizes entity policies, procedures, or staff in some public venue (including a re-election forum), has violated fiduciary duty (and probably board confidentiality). Such action divides the organization, impairs its ability to function as a whole, and potentially damages its reputation and finances--contrary to the absolute requirement to act in the corporate best interest. These actions also, and not merely ones respecting monetary matters, involve advancing a personal agenda ahead of the corporate good, and therefore constitute misconduct. They are also actionable, meaning that a director is personally liable for all damage caused an organization by his/her individual unethical behaviour (plus punitive damages and fines).
This principle also means that a director may act respecting the entity only as instructed by the board as a whole. Making public or private statements while identifying him/her self as a director of an entity, and thereby giving the appearance of acting on behalf of the entity when not instructed by the whole board to do so is misconduct, the degree of which depends on the damage done.
For instance, should a fiduciary of an entity use this fact in signing a letter on a personal or business matter having nothing to do with the entity (but giving the appearance that it does), (s)he has thereby used the position to advance an unrelated personal agenda, and is therefore guilty of misconduct, a violation of fiduciary duty, and becomes personally liable for the entirety of damages resulting (the entity's director insurance notwithstanding, because it is irrelevant in this case). On the other hand, if the entity does not immediately disavow the misconduct by disciplinary action against the rogue fiduciary, it assumes a measure of collective responsibility for the actions, and becomes jointly liable in any subsequent legal action.
Worse still, should a director (or former director) take and use the entity's confidential database to contact members, shareholders, or other stakeholders, say, concerning a matter (s)he disputes with the rest of the board, or in some other opposition to entity policy and decisions, the actionable offences multiply, adding to breach of fiduciary duty those of theft, possession of stolen information, breach of confidentiality and privacy laws, violation of mail or email laws and contracts, and possibly more. With the fine for illicit email contact now generally at $100+ per address per message, rogue behaviour this egregious is likely to attract crushing civil and possibly criminal penalties.
What is more, the fiduciary duty does not end with resignation from a board. A board member who opposes a board decision may not with impunity simply quit the board, then take that opposition public from outside the board, because (s)he is now privy to confidential information, any use of which in public is a violation of the fiduciary duty agreed to by becoming a board member in the first place. That is, any post-board opposition must be based solely on facts generally available to the public, a difficult test to apply.
The only other exception to this "solidarity" aspect of fiduciary duty is whistle blowing a criminal offence, which is not only separately protected and prioritized under statutory law, but generally demanded by it. A director who becomes aware of, say, abusive behaviour by another board member toward the president, or of illicit financial dealings by the CFO, or of illegal business practices, may be required by relevant laws to report fully to the authorities even if the rest of the board prefers to hush the matter. Here, the fiduciary's duty to the larger society is greater than that to the corporate entity served, so the latter must be set aside to conform to the former.
In the Spy's sad experience, disagreements among board members (who must as jointly acting fiduciaries learn to agree to disagree), and/or rogue behaviour by one or more fiduciaries, has been the principal cause for the demise of more than one promising entity. He is aware of several technology companies that once had potentially culture-changing products, yet were unable either to bring them to market in the first place, or to keep them viable in the marketplace, primarily because of corporate governance issues. Most subsequently failed altogether.
The third governance principle is
that directors serve by providing direction, and managers by managing, and the twain should never be mingled. First, note the hackneyed word "serve". There must be an element of altruism in one who would prove worthy of the trust required of a fiduciary. Consider the model provided in the New Testament by the office of church deacon. Their initial task was serving tables. The very word means "servant." A servant takes orders, and though (s)he may participate in shaping them and passing them along, does not personally and individually generate orders, rather obeys them, works within them, never against them. Fiduciary always have a severely constraining legal and policy framework around their actions; they are not free agents, and they step outside this and become Lone Ranger meddlers at their own peril, and that of the entity they are supposedly serving.
The proper purpose and activities of a board encompass giving form and substance to organizational mission, vision, and values, hiring (or recommending to members the hiring of) the president, and possibly one or two other executive positions, approving the budget, and holding the chief officers accountable (through the president) for adherence to their directions and budget.
Yes, the President usually sits on the entity board, but this is largely for effective communication and other practical considerations. Such ex-officio memberships should be kept to a necessary minimum in order to ensure the independence of directors. When directors are not independent of the majority shareholders, the opportunity for fraud is greatest. If other company officers are needed at board meetings, they should attend as non-participating guests.
Further, any employee-director must speak and act with meticulous restraint when participating in substantive board discussions, as the executive officers will eventually be charged with and held accountable for implementing board directives, and should not therefore put themselves into the position of either too closely shaping those decisions or too vigourously opposing what becomes the ultimate disposition, lest they create an intolerable conflict of interest.
The opposite course treads an even more treacherous ground, and sadly, one all too often taken--the director interfering in management. It is too easy (and very grievous) a mistake for a director to perceive the position with such weighty self-importance that it authorizes authoritative intervention in the entity's day-to-day operations. That this is misconduct is a difficult lesson to learn, but a director has no, repeat, zero, management authority unless specifically so charged by the board as a whole. If some internal situation appears to a director to require remedy, (s)he must not do an end run around the board and president by dealing with it directly, but must instead lay it before the entire board, who collectively make and take responsibility for the decision, then instruct the president to carry out their joint will.
A director who unilaterally bypasses the board and the president by directly approaching a staff member with instructions, criticisms, even suggestions on their job performance, or applies pressure on staff to do his/her will, or calls a meeting between staff and disaffected stakeholders to deliver focused criticism, or who enters into or promotes a dispute with personnel, is guilty of a very grave violation of fiduciary duty, and is not only subject to near automatic dismissal by the board (discipline) but also becomes wide open to statutory charges for breach of trust, and to civil or criminal ones for harassment (bullying), with a near certainty in both cases of conviction, heavy fines, and damage awards. The board as a whole must act swiftly and decisively to discipline the rogue lest liability for the misconduct cling to them all.
Likewise, a director who uses the position to show either antipathy or favouritism to a staff member, to a supplier, a contractor, a relative, a friend, an enemy, or some individual stakeholder, also breaches fiduciary duty, the test failed once more being that (s)he would not set aside personal agendas with respect to corporate business.
This is not confined to corporations, for the same principles apply broadly. For instance, a condo association director who uses the position to conduct a vendetta against one unit owner can be prosecuted for said misconduct. Likewise for similar actions directed toward members or staff of a community association or society. Even the church deacon who uses the position to promote a friend or relative for a position of pastor, or tries to have one fired for personal reasons, violates fiduciary duty. Rigid separation of corporate and personal interests, and the absolute prioritization of the former is an absolute requirement of fiduciaries. There can be no exceptions.
The one individual most severely constrained by organizational policy and practice, and therefore the least able to speak to or act upon issues, is the board chair. The person in this position is a "servant of servants" and must on no account join one side or another in an argument. Indeed, the chair must restrain him/her self from expressing a view on issues lest (s)he bias the outcome of decisions or be seen as expressing favouritism. In sound governance, it is unthinkable that a chair lapse into gross misconduct by personally engaging a financial or personal arrangement or, worse still, a dispute with another board member, a staff member, or other stakeholder/shareholder. Such actions by the fiduciary of fiduciaries so compromise the integrity of the board that they may threaten the organization's very existence.
How then shall we act?
In the more informal environment of the seventies through early nineties, a knowledge of sound governance principles seemed to be taken for granted, were considered obvious. The default assumption was that everyone knew fiduciaries always acted with integrity and propriety, and never in self-interest. But there have been so many failures in resource, financial, and high-tech industries in particular, and elsewhere in general, that such an assumption is no longer operative. All organizational entities, whether large corporate conglomerates or small special interest societies, need to take pre-emptive action to institutionalize the principles and prevent the ills described here. As with last month's discussion of spammers, the Spy offers some suggestions (not legal opinions--see disclaimer above).
First Fiduciaries should be selected with the utmost attention to good and sound character, not merely to their qualifications or expertise. Any person with a track record of violating confidentiality, pursuing personal agendas at others' expense, public criticism of authority, misuse of authority themselves, misconduct as a board member, divisiveness, or other love of fighting, should never be a fiduciary, not even of a stamp collecting club. One such misdemeanour may be due to ignorance. Two is a habit implying the offender's character and track record presents too great a risk. Given opportunity, further misconduct is a virtual certainty.
Select those who have a proven track record of professional and personal competence, not putting themselves forward, faithfulness in other responsibilities, are known for absolute integrity, can keep confidences, can discuss frankly and vigourously, yet agree to disagree, in short, have a reputation for being the very kind of person who can faithfully carry out a trust on behalf others without seeking to advance themselves in the doing.
Pick only an experienced and selfless board member with an impeccable record on all counts as chair. Next to the president, the chair is the public face of the organization, and if things go bad at this position, the fallout will be particularly destructive. The chair must be skilled enough to forge and enforce consensus on the board, know when to disallow a director from further repetition of their point of view, and when to cut off debate altogether--all without either stifling healthy discussion or exacerbating disagreements. The wisdom of Solomon or the ability to walk on water may be helpful. This can be a thankless job.
In the event that a chair wishes to speak to an issue, the gavel must be surrendered to another board member for the entire duration of considering that issue, including the vote.
Second, rather than relying solely on statutory law, write a code of ethical conduct for fiduciaries that spells out the principles of loyalty, faithfulness, trust, duty, one-voice joint board action, and absolute non-interference with management. Include specifics related to the particular industry, company, or society. Also incorporate clauses on due process for board discipline for violators. Chances are you will need it. Have corporate counsel explain this in careful detail to new board members, and require a notarized (or at least witnessed) signature of agreement to all points before the person is allowed to take office.
In particular make it clear to board members that if at any time a topic comes up for discussion in which they have a material interest of any kind (such as a contract for a company in which they own shares, or the hiring of a friend) they must absent themselves physically from the meeting for the entire duration of the matter's disposition. The time of their leaving and re-entering the meeting must then be recorded in the minutes. Should this happen on more than an occasional basis, the board member must resign, as (s)he is clearly not able to carry out the fiduciary duty.
Third, Conduct regular professional development with reputable trainers for fiduciaries to reinforce these principles. The cost is trivial compared to that of paying for litigation brought against the entity, or of having to bring it against a rogue board member. Moreover, keep records of what was taught at such courses, so rogue directors cannot excuse unethical behaviour by pleading mere ignorance or incompetence, or by blaming someone else for their misdeeds. Impress upon them that personal liability cannot be escaped even by arguing that the illicit action was well founded, or that the director believed it in the best interests of the entity.
The duty to perform due diligence, especially in the organizations financial, legal, statutory and contractual dealings should be as much a focus of professional development as is the duty of loyalty. Failure to give the entity's affairs careful scrutiny can be catastrophic.
Fourth, If the organization is an unincorporated association or trusteeship, consider incorporating under the state or provincial Society Act. While this will introduce more stringent requirements on reporting, financial statements, public disclosure, membership, meetings, and discipline, it will also bring director conduct under the aegis of specific statutory requirements rather than general common law, making it much easier to obtain a conviction and recover damages in the event of misconduct. Insurance and other issues may also make this course attractive.
Fifth, Follow up diligently on every violation. Employ the Board's Executive Committee or Governance Committee, augmented by corporate counsel, to hear and dispose of complaints against individual board members. Small misdemeanours involving improper letters or speech may be dealt with by an apology, a rebuke and a signed but undated letter of resignation for the miscreant's file (for the net time), but serious improprieties like self-enrichment, public opposition to the board, interfering with management or involving the organization in unrelated external matters, should result in swift dismissal from the board and appropriate legal action to distance the entity from the rogue behaviour and to recover damages. Consult legal counsel at every step. Document everything.
Sixth, Advocate for a better legal regime around the conduct of fiduciaries with the regulatory jurisdictions. Far too often, blatant fraudsters are served a slap on the wrist, nothing more than a prohibition from securities trading or of being a fiduciary for a year. This is usually ignored, and the perpetrators quickly return to the cultivation of the most-recently born suckers. Likewise, those who wreak havoc in an organization by unbridled criticism, divisive behaviour, or other blatant violation of their fiduciary duties, are rarely held to account for their misdeeds. Regrettably, stronger laws, clearly spelling out violations and penalties appear necessary. So does more diligent enforcement. The Spy suggests following the same practice as with child abusers--keeping a formal registry of those who abuse authority, so as to reduce the chance they will gain opportunity to repeat offend (which they surely do given the opportunity; this sort of thing is habitual.)
A last word
As last month, wouldn't it be nice if a column like this never needed to be written? Recall the Spy's first law--that one should not make laws against stupidity. Yet, in the case of fiduciary misbehaviour by directors of companies and societies, that is exactly (and typically--most laws are) what has become necessary. The civilized ethical behaviour that was once assumed, even if it could not always be counted on, has proven illusory. Stronger action against offenders therefore appears indicated. Perhaps some time spent with murderers, drunks, drug pushers, gangsters, and fellow low-lifes in the drunk tank or on a road building chain gang would be a good corrective for white collar criminals. So would a better ability to recover money lost in spurious mining or hi-tech startups, whose only purpose is to enrich a few at the expense of the many.
Failing to pay attention to such matters can be fatal to a corporation or other entity, either preventing that next great product from reaching the market (until Apple does it) or ruining a nice little community club that was on the verge of accomplishing so much. Sadly, a single rogue fiduciary can quickly destroy an otherwise sound organization. To put it another way, organizational failure is almost always a consequence of fiduciary failure, whether intentional or otherwise. A little fraud here, a little puffed-up misconduct there, a little improper meddling with management somewhere else....
Last month, the Spy expressed a "lock them up" sentiment for data base thieves and spammers. Perhaps this month's subtitle for equally criminal misbehaviour by fiduciaries could be "and throw away the key".
Next month, the Spy plans to return to talking product, rather than turkey. But, sometimes you gotta analyse the reasons for the bad as well as praise the good.
--The Northern Spy
Opinions expressed here are entirely the author's own, and no endorsement is implied by any community or organization to which he may be attached. Rick Sutcliffe, (a.k.a. The Northern Spy) is professor and chair of Computing Science and Mathematics at Canada's Trinity Western University. He has been involved as a member or consultant with the boards of several organizations, including in the corporate sector, and participated in industry standards at the national and international level. He is a long time technology author and has written two textbooks and six novels, one named best ePublished SF novel for 2003. His columns have appeared in numerous magazines and newspapers (paper and online), and he's a regular speaker at churches, schools, academic meetings, and conferences. He and his wife Joyce have lived in the Aldergrove/Bradner area of BC since 1972.
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URLs for items mentioned in this column
Society Act of BC: http://www.bclaws.ca/EPLibraries/bclaws_new/document/ID/freeside/00_96433_01#part3
Canadian Encyclopedia on Fiduciary duty: http://www.thecanadianencyclopedia.com/index.cfm?PgNm=TCE&Params=A1ARTA0001938
Canada Business Corporations Act: http://laws.justice.gc.ca/eng/C-44/page-6.html