The Formal Board vs. The Advisory Board

By Charles W. Murdock

The risk of legal liability should not be the controlling element in deciding what type of board is best for you.

Many family businesses in recent years have recognized the value of having some sort of deliberative peer body to provide advice and guidance to management. In some companies that body takes the form of a legal board of directors with a majority of independent outsiders chosen for their business experience and expertise. Other companies, aware of what appears to be a surge in litigation against corporate directors in recent years, have preferred to set up an advisory board of experienced outsiders.

The choice of an advisory board rather than a formal board is usually based, in part, on the owner’s belief that it is easier to attract top talent to a body that presumably has no fiduciary responsibility and therefore cannot be held legally liable for its actions. Serving on an advisory board may no longer be entirely risk-free, however. If an advisory board functions like a board of directors—for example, when the CEO consistently follows board recommendations that are not well founded—the members could run the risk of litigation, if not liability.

Usually, the bylaws of an advisory board provide specifically that the members have no authority to act on behalf of the company and that its recommendations are not binding. The bylaws may also specify that membership is voluntary and can be terminated by the CEO. Presumably, the fact that an advisory board member has no authority and serves at the pleasure of the CEO means he or she should not be held accountable. In reality, the status of legal directors is not much different. Today many corporate statutes provide that shareholders can remove directors, with or without cause. Since the CEO of a family company is often a controlling shareholder, he or she can usually fire a director through the process of a shareholder meeting. The mechanics are more difficult, but the result is the same. While the theory is that the board controls the CEO, the reality is that the CEO controls the board.

The risk of legal liability should not be a controlling element in deciding what type of board is best for a family company. While it is true that advisory board members are less likely to be sued than directors on a legal board, the risks to directors have probably been exaggerated. Much of the litigation brought against corporate directors in recent years has resulted from takeover offers or alleged misrepresentations with respect to market-sensitive information such as earnings forecasts. Since most family businesses are closely held, the likelihood of such public misrepresentations is minimal. Lawsuits involving bad decisions of the management and charging directors with violating the basic “duty of care” in their deliberations are, moreover, relatively rare. Courts simply do not want to be put in the position of second-guessing operating decisions of directors. That is precisely why they developed the “business judgment rule,” under which courts defer to the judgments of directors in such cases—so long as those judgments were based on informed deliberation.

In addition, there are a number of ways of indemnifying directors who act in good faith against costly lawsuits. Under one approach, the corporation itself provides indemnification—that is, it promises to cover any judgments against directors for their actions. Another way is for the company to buy directors and officers insurance for its advisors. Since D&O insurance is expensive, however, it is probably not a realistic alternative for most family businesses.

Another alternative to indemnification is rarely discussed: The controlling shareholders who sit on the board can personally indemnify outside directors by pledging their stock to cover any judgments. The risks of such a strategy are minimal. Since the inside directors control the flow of information and participate in the board’s decisions, they are not likely to sue the outsiders for their role in such decisions. The possibility of a so-called derivative suit by shareholders who do not sit on the board cannot be foreclosed, but if their holdings are not substantial, the indemnification provided by the inside shareholders should adequately protect the nonfamily outsiders.

I have served family companies both as an adviser and a formal director, and I have found that all parties take their responsibilities more seriously when they have legal authority and responsibility. Management will take budgets and forecasts more seriously and make operating decisions more carefully when it knows that they will be reviewed by an outside group. It is only human nature: Whenever people’s actions are going to be closely scrutinized by peers whom they respect, they will be more diligent and circumspect. By the same token, board recommendations have more credibility and are taken more seriously when the members are legally accountable. That is a long way from saying, however, that the board controls operations and should dictate policy to the majority owners.

The theory of the outside board takes seriously the proposition found in all corporate statutes that “the business affairs of the corporation shall be managed by or under the direction of the board of directors.” As is well known, it is extremely rare for public corporations to be truly managed by a board. In a closely held company, it is a total illusion. Management controls the flow of information in every company, and he or she who controls the flow of information controls the the decision-making process.

What should be the composition of a legal board? While an outside board would normally have an odd number of directors, I favor a board that is balanced between three or four outsiders along with three or four insiders, who can be either nonfamily managers of the company or members of the owning family. A balanced board combines the breadth and perspective of independent outsiders with opportunities for family members to participate in the decision-making process. For one thing, that means there are potentially fewer plaintiffs, since family directors are unlikely to sue themselves. But there are other benefits to having more rather than fewer family members on the board.

One is that when possible successors serve as directors, it affords the outside directors a chance to get to know them better and to provide input into their development. Just as important, it helps potential successors and other family members understand policy deliberations and have the experience of being held accountable. Since key managers often report to the board, moreover, family shareholders are exposed to a wider range of information and opinions on the company’s operations, rather than having everything filtered through the eyes of the founding father or CEO. While it might make sense in a public company for the CEO and the CFO to be the only insiders on the board, wider board participation by family members is essential in a family owned enterprise.

I do not believe that having an even number of insiders and outsiders on a board will inevitably result in deadlocks. If a formal board works at all in family companies, it works by consensus, as does an advisory board. Each of the two approaches has pluses and minuses. However, the most important consideration is that both bring peer review and the opportunity for new ideas and new ways of looking at how to do things into the system. For this reason, both are preferable to the stereotypical family board, which is dominated by the CEO and basically operates as a rubber stamp, if it functions at all.

 

Charles W. Murdock is a professor of law at Loyola University Chicago and frequently serves as an expert witness in corporate and securities cases. He and his wife, Moni, work as a team consulting to family businesses.

 

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Spring 1997

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