Contributed By Sullivan & Cromwell LLP
In the USA, there are three principal forms of business organisations: corporations, partnerships and limited liability companies. Some small-business proprietors do not form a business organisation and therefore operate with no liability shield between the business and its proprietor (sometimes referred to as a sole proprietorship).
A corporation is an entity owned by stockholders, managed by a board of directors and established by the filing of a certificate of incorporation or similar filing with the secretary of state of a US state. The board of directors typically delegates day-to-day management to the corporation’s executive officers while exercising oversight over management. A corporation is liable for the obligations of its business, and its stockholders are generally not held liable for such obligations. Corporations are required to observe more formalities as compared to other types of business entities.
For example, state law typically requires a corporation to hold board meetings and annual stockholder meetings. Although corporations have comparatively less governance flexibility and are subject to certain other disadvantages compared to other entity forms (including two-level taxation)), large and widely held public companies are usually organised as corporations, as they are recognised as the traditional corporate form and tend to be the preferred investment vehicle for investors. Certain states provide for other forms of for-profit corporations, such as public benefit corporations and statutory close corporations.
A public benefit corporation is organised for the purpose of a public benefit rather than for the sole purpose of maximising stockholder value. Statutory close corporations (which are required to have fewer than a certain number of stockholders) are typically subject to fewer governance formalities than ordinary corporations.
There are two forms of partnerships: general partnerships and limited partnerships. A general partnership is an entity in which two or more persons carry on the entity’s business. State law typically does not require a partnership to formalise its arrangements, but sophisticated parties often enter into a partnership agreement to specify the rights and obligations of the partners.
In a general partnership, each partner has the authority to undertake transactions, execute contracts and incur liabilities on behalf of the partnership, and is also personally responsible for the obligations of the partnership. Certain states provide for a limited liability partnership, which is a special type of general partnership. In a limited liability partnership, each partner is only personally responsible for liabilities arising from his or her own conduct on behalf of the partnership.
A limited partnership is an entity with two classes of partners, general partners and limited partners, which is formally established by the filing of a certificate of limited partnership or similar filing with the secretary of state. A general partner manages the day-to-day affairs of a limited partnership and is personally liable for the obligations of the limited partnership. Limited partners are mostly passive investors, and their liability is capped at their investment as long as they do not exert active control over the limited partnership.
State law governing limited partnerships is generally flexible, and the governance of limited partnerships can be customised to the desires of the contracting parties.
Limited Liability Partnerships
A limited liability company (LLC) is an entity formed by one or more members by filing a certificate of formation or similar filing with the secretary of state. Similar to a corporation, members of an LLC benefit from limited liability. As with a limited partnership, state law generally permits governance of an LLC to be customised to the parties’ wishes in an operating agreement.
The principal sources of corporate government requirements for US companies are state statutory and common law, an entity’s organisational documents, federal securities law, the rules of stock exchanges and other non-legal sources, such as proxy advisory firms’ guidelines.
State law is derived from a state’s corporate code and related case law. In the US, the most common state of incorporation for Fortune 500 public companies is Delaware, which has implemented the Delaware General Corporation Law (DGCL) to govern the affairs of Delaware companies. The DGCL consists of a set of default and mandatory rules. Incorporators may opt out of the DGCL’s default rules in a corporation’s organisational documents, but a corporation is required to adhere to the DGCL’s mandatory rules.
The expertise of the Delaware judiciary and its active role in the development of corporate case law is a source of perceived strength for Delaware. Entity forms other than corporations will similarly be governed by statutes and case law under state law.
An entity’s organisational documents set forth its governance rules. For example, a Delaware corporation is governed by a certificate of incorporation and bylaws, and, in certain circumstances, a stockholders’ agreement. A general partnership and limited partnership will be governed by a partnership agreement, and an LLC will be governed by an operating agreement.
Acts Pertaining to Corporate Governance
For public companies, the Securities Act of 1933 and the Securities Exchange Act of 1934 (“Exchange Act”), as amended by the Sarbanes-Oxley Act of 2002 (SOX) and the Dodd-Frank Act of 2010 (“Dodd-Frank”), establish certain rules and disclosure requirements pertaining to corporate governance. Historically, the federal securities laws regulated indirectly the corporate governance of public companies through a disclosure regime. However, SOX and Dodd-Frank added substantive corporate governance rules, such as independence requirements for audit committee members.
Public companies with shares listed on national stock exchanges are subject to corporate governance rules issued by the stock exchanges. See 1.3 Corporate Governance Requirements for Companies with Publicly Traded Shares.
Proxy Advisory Firms
Proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass, Lewis & Co (“Glass Lewis”), issue corporate governance guidelines to advise stockholders of public companies on how to vote their shares on corporate governance matters. Passive institutional investors often vote on corporate governance matters in accordance with such guidelines, as well as their published voting policies. Given the trend towards shares being held passively, these guidelines and policies play a significant role in the governance of public companies.
US companies with publicly traded shares are generally required to follow the corporate governance rules and disclosure requirements set forth in the applicable stock exchange rules and the federal securities laws. The USA has several national stock exchanges, including the New York Stock Exchange (NYSE) and the Nasdaq Stock Market (“Nasdaq”). These requirements are mandatory, although the stock exchanges provide exemptions for certain companies, such as those with a controlling stockholder, limited partnerships, companies in bankruptcy, smaller reporting companies, registered investment companies, and foreign private issuers.
The NYSE and Nasdaq require a majority of a listed company’s board of directors to be composed of independent directors, and boards are required to make the affirmative determination that a director is independent. The NYSE definition of independence requires that a director have no material relationship with the company. Nasdaq’s definition of independence turns on whether the director has a relationship that would interfere with the exercise of the independent judgment of the director in carrying out his or her responsibilities. Each of the stock exchanges includes similar bright-line tests that, if satisfied, disqualify a director from being independent.
These tests relate to:
The NYSE and Nasdaq require independent directors to hold executive sessions once and twice a year, respectively, without the presence of management. The NYSE requires disclosure of the name of the presiding director at each executive session or the method by which that presiding director was selected. The NYSE also requires a listed company to disclose the method for interested parties (not just stockholders) to communicate with the presiding director of the executive session or the independent directors as a group.
Composition of Board Committees
Stock exchange rules and the federal securities laws have extensive rules regarding the composition and responsibilities of the audit, compensation, and nominating and corporate governance committees of a listed company’s board of directors.
Listed companies must have an audit committee with at least three members who are independent under the stock exchange rules and Rule 10A-3 under the Exchange Act. In order to be considered independent under Rule 10A-3 under the Exchange Act, audit committee members must not accept any consulting, advisory or other compensatory fee from the listed company or its subsidiaries, or be affiliated with the listed company or its subsidiaries. In addition, Nasdaq precludes a director that participated in the preparation of the financial statements of the company or its subsidiaries in the past three years from serving as an audit committee member.
The NYSE and Nasdaq require all audit committee members to have a certain level of financial literacy and one member to have a certain level of financial expertise. NYSE provides that if a director serves on the audit committee of more than three public companies, the board must determine that such service would not impair the director’s ability to serve effectively on the listed company’s audit committee, and the board must disclose that determination publicly.
Stock exchange rules and the federal securities laws specify certain powers and responsibilities of the audit committee, including:
The NYSE mandates additional responsibilities of audit committees that are not otherwise required by Nasdaq, including:
The NYSE also requires listed companies to maintain an internal audit function, which may be satisfied by an internal department or an outside third party who is not the independent auditor, and the internal audit function must be overseen by the audit committee. The NYSE and Nasdaq rules also govern what types of matters must be addressed in audit committee charters.
Listed companies must have a compensation committee composed entirely of independent directors (subject to a limited exception for Nasdaq companies). In connection with making the independence determination, boards must take into account the following factors under the NYSE rules: the source of compensation of a director, including any consulting, advisory or other compensatory fee to be paid by the company to the director; and whether the director is affiliated with the company or any affiliate of the company. NYSE and Nasdaq require listed companies to have compensation committee charters, which must, among other things, include: the duty of the committee to review and approve and/or make recommendations to the board relating to executive officer compensation; and the ability of the compensation committee to retain and pay compensation advisers.
Nominating and Corporate Governance Committee
The NYSE requires listed companies to have a nominating and corporate governance committee composed entirely of independent directors. Nasdaq permits listed companies to approve director nominations by a majority of a company’s independent directors or a nominating and corporate governance committee composed entirely of independent directors (subject to a limited exception set forth in Nasdaq’s rules). The NYSE and Nasdaq rules also have requirements relating to nominating and corporate governance committee charters.
Ethics and Code of Conduct
Stock exchange rules and the federal securities laws require listed companies to adopt a code of conduct applicable to its directors, officers and employees, addressing matters relating to conflicts of interest, fair dealing, compliance with law and enforcement of the code of conduct.
Corporate Governance Guidelines
Any company listed on the NYSE must adopt and disclose corporate governance guidelines that address matters which include director qualification standards and responsibilities, director access to management and independent advisers, director compensation, director orientation and continuing education, management succession and annual performance evaluation of the board.
In Delaware, directors and officers of a corporation have fiduciary duties of care and loyalty to the corporation and its stockholders. Other states have adopted constituency statues pursuant to which directors and officers are in certain circumstances permitted to consider the interests of constituents other than stockholders, such as customers, employers, the community, suppliers or creditors.
Duty of Care
The duty of care requires a director to act in an informed and considered manner and take the care that a prudent businessperson would take when considering a business decision. A director should review all material information reasonably available when making a decision on behalf of the corporation and should have sufficient time to review the information in advance of making such decision. A director should be afforded the opportunity to ask questions of management and outside advisers.
A director is entitled to rely upon information provided by management and outside advisers in satisfying this duty, unless the director has knowledge that the reliance is unwarranted.
Duty of Loyalty
The duty of loyalty requires a director to act in the best interests of the corporation and its stockholders rather than in their own self-interest or the interests of some other constituency, such as a particular stockholder. A director should either avoid a conflict of interest or disclose the substance of the conflict to the full board.
Under the business judgment rule, if the board has discharged its duties of care and loyalty, courts will not rescind board action if it can be attributed to any rational business purpose. However, if a plaintiff satisfies the burden of showing that the board has failed to discharge its duties of care or loyalty as a result of the existence of a conflict of interest, gross negligent action by the board or that the board acted in bad faith, the board loses the protections of the business judgment rule and its actions are subject to a higher standard of scrutiny from the courts. In certain states, including Delaware, courts apply enhanced scrutiny to board actions under certain circumstances, such as a decision to enter into a transaction constituting a change of control of the company or a defensive action by the board.
Corporate governance reforms continue to be an important topic for US companies.Certain key topical issues include:
There has been an increased focus on diversity in the boardroom. California enacted regulation in 2018 requiring public companies with their principal executive offices in California to include at least one female director on the board by the end of 2019. By the end of 2021, such companies with five board members must have at least two female directors and companies with at least six board members must have at least three female directors.
ISS and Glass Lewis will generally recommend voting against chairs of nomination committees and potentially other directors of public companies with no female director representation. Institutional investors, including BlackRock, Vanguard and State Street, have also campaigned for diversity in the boardroom.
Stale boards (ie, boards with little director turnover) and board refreshment have become a concern for investors as a result of lengthy director tenures, perceived stagnant skill-sets of directors and deficiency of board diversity. Many US companies have responded to the increased investor focus on board composition by instituting board-refreshment plans and including detailed disclosure in their proxy statements regarding board-refreshment plans. Companies have also pursued other remedies, such as annual evaluations of the board and mandatory retirement ages and term limits for directors.
Not all remedies have been well received, as ISS recommends that shareholders vote against proposals for mandatory retirement ages and term limits.
#MeToo and Sexual Harassment
Sexual harassment claims against executives have resulted in significant consequences for corporations and their stakeholders. In addition to the profound impact on the victims, these claims can lead to litigation, departure of management and impact to business reputation and employee morale. Investors and the public expect that boards and management will instill a company culture that protects against sexual harassment.
A board should ensure that a company has robust procedures in place relating to the reporting of and timely reaction to sexual harassment allegations. A board should also identify the personnel responsible for sexual harassment investigations, such as audit committee members and outside advisers.
Shareholder Activism Objectives
Shareholder activism remains steady in the US and continues to be top of mind for boards of public companies. The number of proxy contests and other activism campaigns in 2019 remained largely consistent with those in 2017 and 2018. Recent activism campaigns have largely focused on M&A-related initiatives and balance-sheet actions, such as requiring a company to issue dividends and initiate share repurchases.
Of the 2019 campaigns that were M&A-related, 32% called for a sale of the company or consolidation, 33% pushed for a divestiture or break-up of the company and 35% attempted to block or interfere with an announced deal. Recent studies of M&A-driven activist initiatives have demonstrated activists’ conviction to follow through with their campaigns. Nearly 50% of companies that added activist designees to their boards in 2017 or 2018 have since either sold themselves or completed meaningful divestitures.
Of note, activists attempted hostile takeovers in a few notable instances in 2019. It remains to be seen whether hostile takeovers become a mainstay for the activist toolkit.
Public data breaches have had a significant impact on targeted companies’ reputations with consumers and regulators. Given the wide-reaching impact of compromised data, cybersecurity has increasingly required board attention and oversight. Boards are increasingly called upon to oversee cyber-related issues and to have a working knowledge of the company’s compliance efforts.
This trend requires boards to be prepared for a cybersecurity incident, proactively identify advisers and experts and actively engage with the company’s oversight framework around cybersecurity threats.
Virtual Stockholder Meetings
Virtual-only annual meetings have become an increasingly common practice among US public companies in recent years, although in-person annual meetings were significantly more popular than virtual-only meetings prior to the COVID-19 pandemic. Companies in favour of this format argue that the virtual format allows for increased shareholder participation in an efficient, cost-effective manner. While some investors and proxy advisory firms have raised concerns regarding virtual stockholder meetings, as discussed in 2.4 The Impact of COVID-19 on Governance, many companies switched to or are evaluating the use of virtual-only stockholder meetings in light of COVID-19.
The proxy advisory firms have recently relaxed their views regarding virtual-only stockholder meetings in light of COVID-19 but will require companies to provide comprehensive disclosure regarding the procedures of the meetings in order to receive favorable recommendations.
In the US, the federal securities laws do not specifically require ESG-related disclosure. Instead, ESG matters are subject to the same principles-based approach and materiality standard that applies to other types of disclosure under the federal securities laws.
Despite the absence of SEC-mandated ESG disclosure, there has been a significant rise in shareholder proposals and voting policies calling for ESG disclosure. In 2018 and 2019, ESG-related proposals were the largest category of proposals submitted to public companies, likely as a result of the increased focus on ESG issues by proxy advisory firms and large institutional investors. Blackrock, for instance, stated that it would make climate change and sustainability a core goal of its investment strategy.
In March 2020, ISS launched its Climate Proxy Voting Policy, which provides specialty voting guidelines relating to climate issues. For a discussion of examples of topical ESG issues, including board diversity and refreshment and #MeToo, see 2.2 Current Corporate Governance Issues and Developments.
To keep pace with the increased focus on ESG issues, companies have increasingly engaged with investors on ESG matters through a broad array of channels, including periodic sustainability reports and ESG-related conference calls. As Regulation FD prohibits selective disclosure of material, non-public information, companies may be required to make additional public disclosure on ESG matters in order to satisfy their obligations under Regulation FD. The increased focus on ESG has also given rise to a host of recognised voluntary ESG reporting frameworks, including standards developed by the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD).
Annual Shareholder Meetings
In response to COVID-19, states including New York, California and Delaware issued executive orders permitting or facilitating virtual-only meetings under their respective state corporate laws. The SEC also provided guidance on various shareholder meeting-related issues, including guidance on notification of changes in date, time or location of shareholder meetings and disclosure of the logistical details of a virtual shareholder meetings. ISS and Glass Lewis issued guidelines relaxing their voting policies on virtual-only meetings so long as companies provide comprehensive disclosure on the procedures of such meetings.
In jurisdictions where virtual meetings are prohibited, ISS will favourably view companies that engage with their shareholders electronically, including through webcasts and conference calls, if the companies choose to postpone their annual meetings.
Securities Filings and Reporting
To address potential securities compliance issues in light of COVID-19, the SEC enacted conditional relief for certain securities filing and reporting obligations, including an extension for companies to file certain disclosure reports. In addition, the SEC also provided guidance encouraging companies to timely disclose COVID-19 and related business and market disruptions, while emphasising that health and safety should not be compromised to meet reporting requirements.
The NYSE waived certain shareholder approval requirements under its rules in order to assist companies with urgent liquidity needs raise capital more expeditiously. In light of the pandemic and the potential need for urgent board and management changes, ISS issued guidance stating that boards should have broad discretion during the COVID-19 crisis to ensure that they have the right team in place and would adjust the application of their policies accordingly.
In light of COVID-19, ISS issued guidance stating that a severe stock price decline as a result of the pandemic will likely be considered a valid justification in most cases for adopting a poison pill with less than one year in duration without a shareholder vote. In such circumstances, boards should provide detailed disclosure regarding their choice of duration or on any decisions to delay or avoid putting plans to a shareholder vote beyond such duration period.
Disclosure Controls and Insider Trading
The pandemic may present higher risks of disclosure controls and insider trader issues as many employees are working from home and new material non-public information may hold an even greater value than under normal circumstances. In response, the SEC issued a statement emphasising market integrity and urged public companies to continue to comply with their established disclosure controls and insider trading prohibitions.
In the USA, state law generally delegates the authority to manage the business and affairs of a corporation to a board of directors. A board of directors typically delegates day-to-day management of a corporation to its executive officers while exercising oversight over management. The boundaries of a board’s delegation to management may be documented by a board-approved delegation of authority that sets forth what types of decisions and transactions above what thresholds require board approval.
A board may also delegate certain responsibilities to committees, including audit, compensation and nominating and corporate governance committees as required by public companies listed on the NYSE or Nasdaq. Boards may also form other committees for the purpose of pursuing certain objectives, such as forming a strategic alternatives committee to explore potential fundamental changes to the strategic direction of the company (often including a potential sale of the company) or a special litigation committee to address stockholder derivative litigation.
Stockholders do not actively manage the business and affairs of a corporation, but instead exert influence on a corporation by voting, making stockholder proposals, acquiring board seats by nominating directors or settling with the board and publicly or privately communicating to the board and/or management.
Limited Liability Companies
The governance structure of an LLC depends on whether the LLC has one or more members and whether it is managed by its members or managers. A single-member LLC will typically be managed by its owner. A multi-member LLC may be managed by its members or by outside managers. Freedom of contract is a fundamental principle of US LLCs, so management authority in a multi-member LLC can generally be tailored in the operating agreement to the contracting parties’ needs.
In a general partnership, each partner has the authority to undertake transactions, execute contracts and incur liabilities on behalf of the partnership, and is responsible for the day-to-day affairs of the partnership by default. In a limited partnership, management authority is delegated to a general partner, and limited partners will not have management authority over the business. Similarly to LLCs, limited partnerships follow the freedom of contract principle, so management authority in a limited partnership may also be tailored to the contracting parties’ needs in the limited partnership agreement.
However, limited partners may lose the protection of limited liability if they participate in day-to-day management of the business.
A board of directors of a corporation in the USA typically makes decisions relating to the following matters:
Stockholders typically have approval rights under state law or the stock exchange rules for the following actions:
In an LLC or a partnership, decision-making authority may be tailored to the contracting parties’ wishes within certain parameters in the LLC operating agreement or the partnership agreement.
A board of directors of a corporation in the USA makes decisions by passing resolutions at a board meeting or by written consent if permitted by applicable state law and the company’s organisational documents. In advance of a board meeting, directors are typically provided by management or outside advisors with a meeting agenda and written materials to ensure the directors are properly informed on the topics to be discussed at the board meeting. Board meetings often include management presentations on the relevant topics and an executive session in which the board deliberates without the presence of management or any management directors.
At the meeting, the secretary of the corporation will typically keep board minutes as the official record of board deliberation and action.
Stockholder action may be taken at annual or special meetings or by written consent if permitted by applicable state law and the company’s organisational documents. In an LLC or a partnership, action may be taken at meetings or by written consent, as may be set forth in the LLC operating agreement or the partnership agreement. There is generally no requirement to hold meetings.
A typical board structure for a US company is a single class of directors elected annually with standing committees that are delegated authority by the board to be responsible for certain matters such as audit, compensation and corporate governance matters. Directors may be elected by plurality or majority voting, depending on state law and a company’s organisational documents. The board’s authority to delegate matters to committees is typically broad, and committees will generally have the full authority to exercise the power of the board, subject to limited exceptions.
State law typically permits boards to be staggered into separate classes that are up for election less frequently than annually, but generally for no longer than every three years. Staggered boards have become less common among US public companies, largely due to oppositions from proxy advisory firms and institutional investors.
A board of directors of a public company is typically comprised of management directors and independent directors. Management directors generally have more intimate knowledge of the corporation’s affairs as compared to independent directors. Certain states hold management directors to a higher standard of care due to their knowledge of and active involvement with the business.
Independent directors are generally permitted to rely within reasonable limits on information provided by management and outside advisors in satisfying their fiduciary duties.
Stock Exchange Rules and Federal Securities Laws
Stock exchange rules and the federal securities laws bear on the roles of directors in public companies. Subject to certain exceptions, stock exchange rules require listed companies to have audit, compensation and nominating and corporate governance committees comprised only of independent directors. Investors are increasingly focused on boards having a diversity of expertise to enable them to serve as effective committee members and make informed decisions regarding the management of the corporation.
There has been a trend of public companies disclosing in proxy statements the expertise of their directors in the form of board skill matrices, which identify skill-sets such as finance and accounting, risk management, shareholder engagement and governance.
Composition requirements of US boards are driven by stock exchange rules, federal securities laws, state law, and proxy advisory firm guidelines.
Stock Exchange Rules
Subject to certain exceptions, both the NYSE and Nasdaq rules require a majority of a public company’s board to be independent, and only independent directors may serve on the audit, compensation and/or nominating and corporate governance committees. The NYSE and Nasdaq have bright-line tests relating to whether a director qualifies as independent, which must be affirmatively determined by the board. See 1.3 Corporate Governance Requirements for Companies with Publicly Traded Shares for a detailed discussion of the NYSE and Nasdaq requirements on director independence.
Federal Securities Law
The federal securities laws require each member of an audit committee to be independent and provide an overlay of independence requirements for audit committee members. See 1.3 Corporate Governance Requirements for Companies with Publicly Traded Shares for a discussion of independence requirements under Rule 10A-3.
State law typically does not require directors to be independent. Having independent directors, however, may be favourable to a company and its directors from a stockholder litigation perspective. For example, in the context of a conflicted corporate transaction (ie, a transaction in which an officer or director has an interest on both sides of the transaction), review and approval (or ratification) by disinterested directors (along with the implementation of other procedure protections, such as stockholder approval) may subject such a transaction to a more deferential standard of review by the courts.
Proxy Advisory Firms Guidelines
The proxy advisory firms have published extensive guidelines that relate to board composition. ISS guidelines stress board independence, the existence of audit, compensation and nomination committees composed of independent directors and establishing leadership positions for independent directors, including as board chairs.
Directors of US public companies are typically elected by a majority of the stockholders entitled to vote at a meeting. In the event of a vacancy or a newly created directorship, a majority of directors are generally permitted to fill that vacancy or newly created directorship unless otherwise provided by the corporation’s organisational documents. Typically, stockholders may remove a director with or without cause unless the board is staggered or the corporation has cumulative voting.
If the board is staggered, a director may only be removed for cause unless otherwise provided for in its charter.
Officers are appointed by the board or other governing body of the corporation, and the offices of a corporation are typically set forth in the corporations’ bylaws or in board resolutions. An officer may be removed by the board without cause, subject to contractual protections in that officer’s employment agreement.
See 1.3 Corporate Governance Requirements for Companies with Publicly Traded Shares and 4.3 Board Composition Requirements/Recommendations for a discussion of rules and requirements relating to director independence.
The federal securities laws and state law provide rules relating to director conflicts of interest. Under the federal securities law, public companies are required to disclose any transaction over USD120,000 that has occurred since the last fiscal year or is currently proposed, in which the company is a participant and any related person (defined to include directors) has or will have a direct or indirect material interest. The federal securities laws also mandate the disclosure of a company’s related-party transactions' policies and the directors responsible for applying such policies.
Under state law, conflicted transactions may be voidable and/or subject to a duty of loyalty claim by a stockholder. States typically adopt safe harbour statutes for conflicted transactions, which provide that such transactions are not per se voidable if the material facts relating to the conflict are disclosed to the board, the transaction is approved by the non-conflicted directors or stockholders and/or the transaction is fair to the company. A company will also be in a better position to defend a stockholder’s duty of loyalty claim if it takes any or all of the steps outlined in the preceding sentence.
See 2.1 Key Corporate Governance Rules and Requirements.
In Delaware and many other states, directors and officers owe fiduciary duties to the corporation as an entity and to its stockholders. In the case of insolvent corporations, that duty requires directors and officers to manage the company for the benefit of all residual beneficiaries, and creditors of insolvent companies may enforce these fiduciary duties against directors.
Certain other states have various forms of constituency statutes, which permit the board in certain circumstances to balance the interests of stockholders against interests of other constituents, including customers, employers, suppliers or creditors. In addition, directors of public benefit corporations are required to consider the interests of the public, not just those of the stockholders.
Fiduciary duty claims against a director may be claims brought directly by the corporation or by its stockholders on behalf of the corporation or, in some instances, on their own behalf. The consequences of a breach of fiduciary duty may be monetary damages or equitable relief. A director is typically protected from personal monetary liability arising out of duty-of-care claims in several ways.
First, courts typically apply the business judgment rule when reviewing the business decisions of a director. Second, states typically permit corporations to adopt provisions in their organisational documents that provide for the exculpation and/or indemnification of directors for losses and expenses incurred in connection with a duty-of-care claim. Third, states typically permit corporations to purchase liability insurance for their directors to cover losses resulting from fiduciary duty claims, including duty of care and loyalty claims.
Courts evaluate board action under different standards of review, depending on the facts and circumstances underlying the board action. As discussed in 2 Corporate Governance Framework, business judgment review is the default standard for courts to review board action. If a plaintiff satisfies the burden of rebutting a presumption underpinning the business judgment rule, courts in most states apply “entire fairness”, the most onerous standard of review, to board action, which requires the board to establish that a transaction was a product of fair dealing and fair price.
Courts in certain states, such as Delaware, apply enhanced scrutiny (which is an intermediate standard of review) to board action in certain circumstances, regardless of whether the presumptions underlying the business judgment rule have been satisfied, such as a board’s decision to enter into a transaction constituting a change of control of the company or to adopt a defensive action, such adopting a poison pill. In circumstances where enhanced scrutiny applies, boards are required to take certain actions that they would not otherwise be required to take, such as seeking a transaction offering the best value reasonable available to stockholders in a change-of-control scenario.
Breaches of Corporate Governance Requirements
In addition to the core fiduciary duties of care and loyalty, Delaware and many other states recognise certain other corporate law doctrines supporting claims against directors or officers for breaches of corporate governance requirements. For example, in Delaware, board action intended primarily to interfere with the shareholder “franchise”—ie, core rights incident to share ownership, such as voting rights—must be justified by demonstrating a compelling justification for taking such action. Another example is the corporate waste doctrine, under which directors have a duty not to approve a “wasteful” transaction, which no person of ordinarily sound business judgment would find fair or acceptable.
Delaware law also imposes on directors a duty to disclose all material information in certain circumstances, including self-dealing transactions.
For a discussion of limitations on director and officer liabilities, see 4.6 Legal Duties of Directors/Officers.
Compensation for executive officers and directors is often determined by the board of directors, and this responsibility is often delegated to compensation committees (or nominating and corporate governance committees, in the case of director compensation). In Delaware, the board’s decisions regarding executive compensation are protected by the more deferential business judgment rule. A conflict of interest resulting in application of the entire fairness standard (which often survives a motion to dismiss) may arise where directors approve compensation arrangements for themselves.
In recent years, many companies have included a limit on non-employee director awards (typically structured as an annual cap) in stock incentive plans submitted for stockholder approval. This was in response to a line of Delaware Court of Chancery cases suggesting that if a company’s shareholders approved a plan with “meaningful limits” on director awards, subsequent challenges to awards within those limits would be entitled to the business judgment rule rather than the entire fairness standard. A December 2017 Delaware Supreme Court decision in Investors Bancorp called into question whether these limits are adequate for business judgment protection but did reiterate that director awards made in accordance with shareholder-approved specific amounts or formulas will be protected.
The federal securities laws require a public company to include a non-binding shareholder vote in their proxy statements to approve the compensation of their named executive officers (generally, the CEO, CFO and three other most highly compensated executive officers) (commonly referred to as the “say-on-pay” vote) at least once every three years and a separate vote to determine how often the say-on-pay vote will be held (“say-when-on-pay”) at least once every six years.
The NYSE and Nasdaq listing standards require listed companies to receive shareholder approval for most equity compensation plans (and material amendments).
The federal securities laws require extensive disclosure regarding the compensation of executive officers and directors in a public company’s proxy statement. The disclosure focuses on compensation for the company’s named executive officers, who are, generally, the principal executive officer, the principal financial officer, and the three other most highly compensated executive officers; however, additional executives may be included in this group because of turnovers during the applicable year.
The Compensation Discussion and Analysis (CD&A) must explain the material elements of the company’s compensation for the named executive officers and is intended to facilitate investors’ understanding of the numbers in the requisite tables that follow the CD&A. A short compensation committee report is also required by the proxy rules.
Summary Compensation Table
The main table required to be included in a company’s proxy statement is the Summary Compensation Table, which generally discloses the compensation earned by each named executive officer for each of the prior three fiscal years by category: salary, bonus, stock awards, options awards, non-equity incentive plan compensation, change in pension value and non-qualified deferred compensation earnings, other compensation and total compensation. Other required tables must include information relating to grants of equity and bonus awards made to each named executive officer in the last fiscal year, outstanding equity awards at the end of the last fiscal year, stock options exercised by the named executive officers and stock awards that have vested during the last fiscal year, pension benefits, and non-qualified deferred compensation. Companies must also provide narrative or tabular disclosure regarding the circumstances in which a named executive officer may be entitled to compensation upon termination of employment or in connection with a change in control, including estimates of potential payouts.
A public company must also disclose the ratio between the CEO’s annual total compensation and median of the annual total compensation of all other employees. Director compensation for the most recent fiscal year is also required to be disclosed in a table that is similar to the Summary Compensation Table, along with related narrative disclosure.
Stockholders are the owners of a corporation. This relationship is governed by state law. If the corporation is public and listed on a stock exchange, this relationship will also be governed by stock exchange rules and the federal securities laws.
This relationship will also be influenced by other sources, such as proxy advisory firm guidelines.
Under state law, stockholders have no involvement in the management of a corporation, which is vested in a board of directors and often delegated to executive officers by the board. State law generally enumerates certain actions that require stockholder approval, which is further discussed in 3.1 Bodies or Functions Involved in Governance and Management.
Annual meetings of stockholders of a corporation are generally required under state law for the election of directors. For example, in Delaware, if a corporation fails to hold its annual meeting 30 days after the date designated for the annual meeting or 13 months after its last annual meeting, the Delaware Court of Chancery may order a stockholder meeting upon the application of any stockholder or director. Special meetings of stockholders may be called by the board of directors or any other person authorised by a corporation’s organisational documents, such as stockholders. Corporations may explicitly prohibit the ability of stockholders to call special meetings in their organisational documents as a defence against stockholder activism.
State law governs the mechanics of holding a stockholder meeting. In Delaware, the location and time of annual meetings may be established in a corporation’s organisational documents or by the board. Written notice of a meeting must be given to stockholders entitled to vote no fewer than ten days and no more than 60 days before the date of the meeting. The board is required to fix a record date for the purpose of establishing which stockholders are entitled to notice and the right to vote at a stockholder meeting, which must be no fewer than ten days and no more than 60 days before the date of the meeting.
Quorum requirements may be set in a corporation’s organisational documents but may not be less than one third of the shares entitled to vote at the meeting. Delaware law generally does not govern the type of business to be conducted at a stockholder meeting, but corporations may include rules in their organisational documents or publish rules and/or agendas. For example, it is common for public companies to adopt advance notice bylaws, which require stockholders wishing to nominate a director or make a stockholder proposal to satisfy certain procedural and substantive requirements in order for their nomination or proposal to be properly raised at a stockholder meeting.
In Delaware, stockholders may take action by written consent without holding a stockholder meeting unless prohibited by the corporation’s charter.
A stockholder may file direct claims against the corporation or its officers and directors for actions that directly harm the stockholder or derivative claims against the corporation’s officers and directors for actions that harm the corporation. A common example of a derivative claim brought by a stockholder is a breach of fiduciary duty by the board.
Prior to filing a derivative claim, a stockholder must demand that the board pursue the claim or, in most states, including Delaware, demonstrate that such a demand is futile because of the board’s disinterest or conflict of interest with respect to the litigation. This procedural requirement does not exist for direct claims, so stockholders at times try to refashion derivative claims as direct claims.
The Federal Securities Law
The federal securities law requires an investor or group of investors who acquire beneficial ownership of more than 5% of a public company’s voting equity securities to file reports relating to their ownership on Schedule 13D, or if eligible, on Schedule 13G. Passive investors that own less than 20% of a company’s equity securities are eligible to report that ownership on Schedule 13G and are otherwise subject to a less onerous reporting regime than that applicable to Schedule 13G filers. An investor who acquires more than 5% of a public company’s voting equity securities, and is not eligible to file a Schedule 13G, must report the acquisition on a Schedule 13D with the Securities and Exchange Commission (SE”) within ten days of crossing the 5% threshold.
Schedule 13D requires the disclosure of the identity of the investor, information about the investor’s ownership of the company’s securities and sources of funds, any of the investor’s arrangements with respect to securities of the company and the purpose of the acquisition, including any plans or proposals which the investor may have to make changes to the board or management or to consummate a corporate transaction. The Schedule 13D must be amended promptly as a result of any material changes in the disclosure to the original Schedule 13D which include the acquisition or disposition of one percent or more of the class of equity securities of the company. Subject to certain exceptions, an investor eligible to file a Schedule 13G must file the report within 45 days after the end of the calendar year in which the investor first became obliged to make such a filing.
Institutional Investment Managers
Institutional investment managers that have assets under management of at least USD100 million must report to the SEC their holdings of exchange-traded equity securities, certain equity options and warrants, shares of closed-end investment companies and certain convertible debt securities on Form 13F within 45 days of the end of each calendar quarter. Form 13F requires disclosure of the name of the manager, the name and class of security holdings and the number of shares and the market value of such shares as of the end of the calendar quarter.
Beneficial owners of more than 10% of any class of equity security of a public company (as well as directors and officers) must report their beneficial ownership of equity securities on Section 16 forms. Transactions in equity securities by such stockholders, directors and officers must generally be reported within two business days. These parties may be required to disgorge to the company any profits made in connection with the purchase and sale of company securities within a six-month period.
Acquisitions of Voting Securities
Certain acquisitions of voting securities by an investor must be reported to the Federal Trade Commission (FTC) and the Department of Justice (DOJ) prior to consummation if the transaction value and the sizes of the investor and issuer exceed certain thresholds pursuant to the Hart Scot Rodino Antitrust Improvements Act. Upon the investor making the filing, the FTC and DOJ have a 30-day period in which to request further information from the investor to determine whether the acquisition violates the US antitrust laws. If the investor requests and is granted early termination of this waiting period, the names of the parties are published. Unless early termination is granted, the filing is not made public.
The contents of the filing are confidential in all cases. Stockholders should be mindful of other regulatory regimes that may be implicated by a stockholder’s acquisition of shares, including, among others:
The federal securities laws require public companies to file publicly annual, quarterly and current reports relating to the occurrence of certain events material to stockholders. Annual and quarterly reports must be certified as accurate and complete by a company’s CEO and CFO. Public companies are also required to file proxy statements in connection with their stockholder meetings.
The federal securities laws require public companies to disclose the following information relating to corporate governance in their proxy statements:
Public companies must also disclose the occurrence of certain events in a current report, including:
The federal securities laws also require a public company to post on its website its nominating committee, audit committee and compensation committee charters or include the charters as an appendix to its proxy statement every three years. The NYSE requires its listed companies to make its code of business conduct and ethics publicly available on or through its website.
State law generally requires corporations and certain other entity forms to file with the Secretary of State the charter for a corporation. Certain states also require corporations and certain other entity forms to file annual or biannual reports, which generally require basic information about the entity, such as its legal name, address, registered agent and names of directors and officers. States typically make these filings publicly available.
The federal securities laws require public companies to have an independent auditor review their financial statements and disclosures and provide an opinion as to their fairness and compliance with the Generally Accepted Accounting Principles (GAAP).
The SEC considers the independence of an auditor impaired if the auditor is not, or a reasonable investor with knowledge of all attendant facts and circumstances would conclude that the auditor is not, capable of exercising impartial judgment on all issues encompassed within the audit engagement. In addition, certain actions and arrangements between a company and its outside auditor are not permitted, including contingent fee arrangements, direct or material indirect business arrangements between a company and its outside auditor and a company hiring certain employees of the independent auditor during a one-year cooling-off period.
SEC rules prohibit independent auditors from providing certain non-audit services to a company, including but not limited to bookkeeping, management or human resource functions or legal services and unrelated expert advice. Independent auditors may provide other non-audit services to a company that are not specifically prohibited by SEC rules as long as the audit committee provides pre-approval. A company’s audit committee is responsible for the oversight of its independent auditor.
The federal securities laws require a public company to maintain adequate internal controls over financial reporting (ICFR) in order to provide reasonable assurances with respect to the reliability of the company’s financial reporting and compliance with GAAP measures. A company’s principal executive and financial officers are responsible for the design and implementation of the internal ICFR regime and must report control deficiencies and related findings to the audit committee and the company’s independent auditor. Subject to certain exceptions, companies are required to include a management-drafted internal control report with their annual report and a related attestation by the company’s independent auditor.
NYSE requires a company’s audit committee to oversee risk assessment and risk management policies. Federal securities laws only require the disclosure of the board’s role in the company’s risk oversight process. For a discussion of these disclosures, see 6.2 Disclosure of Corporate Governance Arrangements.