Exit right

By Peter McCann
Illustration: Mike Constable

Directors who know when to leave act in the best interests of a corporation. But how many do? Here’s a guide that shows when and how to quit

You have been a director on the board of ABC Inc. for a number of years now. Lately, you have been beset by persistent, niggling questions. You have asked yourself again and again if there are factors that limit your ability to prudently serve on the board. You wonder if you should leave and if it is duty that compels you to stay. Should you seek legal advice independent of the company and, perhaps, the board?

These are questions directors of corporations and nonprofit organizations should periodically ask. Evaluation of these types of questions is a renewal of commitment.

The director’s duty is well established: to act in the best interests of the corporation or organization (duty of loyalty) in the same way a reasonable person with similar qualifications in similar corporate or organizational circumstances would (duty of care). Similar qualifications means CAs and other professionals may sometimes be at greater risk than non-CAs and nonprofessionals.

Table one (please see "Should I stay or should I go?" on page 36) lists common impediments and differences that may limit a director’s ability to fulfil the duty of loyalty and the duty of care.

Before turning our attention to the risks, the age and tenure topic deserves a brief comment.

One of the most thoughtful, experienced and nuanced directors in Canada is William Dimma. He has served on more than 50 corporate boards and another 40 not-for-profit boards. I would take one of him for any two directors that I could think of. Dimma is in his 70s and cannot in any way be said to be past the best-before date. Some corporate bylaws may force the departure of directors due to age and tenure — we may lose tremendous experience and insight as a result.

Another topic that deserves a brief comment is illegality and ethical violations.

No honest director would or should be a party to or condone illegalities and ethical violations, and no honest director would or should legitimize illegalities and ethical violations by continued service as a director. A great question is: am I ready to explain this on the front page of the local newspaper? However, there may be a strong argument for staying as a director in a situation like this. Staying on provides the director with an opportunity to fully exercise his or her skills and commitment and to discharge the duty of loyalty and the duty of care. Resigning simply leaves the robbers free to loot the bank vault.

SHOULD I STAY OR SHOULD I GO?

Impediments

Over-commitment
Health and distractions
Age and tenure
Inexperience and lack of skills
Dysfunctional boards
Conflicts of interests
Inadequate resources and cooperation

Differences

Differences on the CEO and strategy
Illegality and ethical violations

Risks
In Confessions of an Ex-Secret Service Agent: The Marty Venker Story, Venker and his coauthor tell how Ronald Reagan saw his Secret Service guards standing erect during shooting practice and asked why, since in the movies shooters crouch for stability. One guard replied, "We take bullets, too." Directors are the Secret Service guards of their companies, their shareholders and, sometimes and to some extent, their companies’ stakeholders. But, should directors take bullets, too?

The risk of bullets is the risk to the director’s reputation and the risk of financial liability. Today, directors have liabilities for the corporations’ conduct (for example, environmental and labour violations, unpaid taxes). This means directors have liabilities that investors and entrepreneurs who establish companies are protected from. There are also professional liability issues. The law imposes the risks and the courts enforce the liabilities.

Trial by media imposes additional risks and penalties, with little defence or recourse. The story of Environmental Management Solutions Inc. (EMS) provides a powerful example. As The Globe And Mail reported in February this year: "When Ottawa entrepreneur Frank D’Addario turned to Brian Tobin for some help recruiting new directors to the board of his small public company just over a year ago, no one was prepared for the outcome." The story of the board’s subsequent fallout with D’Addario followed, and several sterling directors of EMS have faced regular media coverage of their decisions and the proxy fight that followed. Most directors don’t want that kind of attention.

Corporate deterioration and risk
Deteriorating corporate financial performance may substantially increase a director’s reputational and liability risks. Typically, early stage corporate deterioration is mild and slow — sales may slightly decline, products may become slightly less technologically competitive, or aggressive competition may enter the company’s market and product niches. Meanwhile, the company continues to remit to governments, pay wages and vacation pay and maintain in good repair the brakes on the company’s trucks. The directors may perceive no increase in reputational and liability risks, although the mid- and long-term risks have risen.

As the company’s financial performance further deteriorates and the company approaches the vicinity of insolvency, the company will be under cash flow and even subtle banking pressure to delay government remittances, payments to suppliers and maintenance on the brakes on the company’s trucks. In the late stages of corporate deterioration the reputational and liability risks to a director will escalate in amount and probability.

A director lacking skills appropriate in the circumstances and the availability of time to contribute to a correction may quite reasonably decide to resign at the first persuasive sign of deterioration. Having failed to arrest the deterioration, a director may resign to make way for one more capable or available for the new corporate reality — if a new, capable, available, risk-tolerant director can be found.

Since each director is obligated to a duty of loyalty to the company, resignation only for the reason of risk avoidance may be viewed as disloyalty by fellow directors and some shareholders. In fact, resignation under the circumstances of deteriorating corporate performance has been character

Quantification of risk-adjusted directors’ liabilities
Unease with increased risk and stress may influence a director’s decision to serve or to resign; however, a rough estimate of the liability risk and the potential shareholder value at risk will help a director make a more informed, rational decision.

The graph "Market capitalization and risk-adjusted directors’ liabilities" on page 36 illustrates a hypothetical example of increased directors’ liabilities and decreased shareholder value. Three observations should be borne in mind. First, a personal liability may arise from a failure by a director to fulfill the duty of loyalty and the duty of care. A joint and several liability may arise, for example, from a failure to pay certain wages; being a joint and several liability, each director would be liable for 100% of the unpaid wages. Second, potential liabilities should be considered on a risk-adjusted basis; two weeks’ wages of $1 million accrued by a company in the vicinity of insolvency is much more likely to become a real, rather than a hypothetical, directors’ liability than the same amount accrued by a thriving company. Third, the shareholder value at risk is simply the market capitalization.

The graph was constructed by applying those observations to data from a business school case and some estimates. As financial performance deteriorates, the share price decreases and can be expected to collapse when the company is perceived by investors to be likely to enter the vicinity of insolvency. Concurrently, the amount of directors’ liabilities is nominally constant but the risk-adjusted liabilities rise sharply as the probability of insolvency increases. By the fourth year — the Scenario Year — the individual director’s risk-adjusted liability, bearing in mind the joint and several nature of certain directors’ liabilities, will be greater than the total market capitalization of the company. In other words, one director may have more financial exposure than all the shareholders.

The inescapable conclusion is that a rational director should exercise great loyalty and care, get independent legal advice and then resign. However, after receiving independent legal advice, a rational director may decide to stay to staff the bilge pumps if he or she has a high risk tolerance or a low personal net worth due to sheltering or other reasons and a belief that the director can and will make a positive contribution to the remediation of the company.

Risk and risk management
The obvious risk management technique is to serve with loyalty and care. Unfortunately, mistakes do happen, and some companies deteriorate. Corporate indemnification agreements, through the bylaws or by contractual agreement, may be broken umbrellas in a storm when a company becomes insolvent and is unable to pay any indemnification. Directors and officers insurance provides comfort and protection, subject to the terms and exclusions in the policy. Sheltering of a director’s personal assets is another form of risk management. If the various risk management provisions are considered deficient by independent legal counsel, a director should consider resignation.

How to jump
Paul Simon sang 50 Ways To leave Your Lover. In fact, there are only a few ways, with many variations. There are also only a few ways to leave a board: death, be asked to step down or not be renominated, defeat at an annual general meeting election, mandatory retirement or rotation, or resign.

Death is the least attractive departure. If leaving due to mandatory retirement or rotation, a sincere, positive, brief statement is civil and dignified. If resigning, the question is: go quietly or make a public statement? Generally, the resignation of a director with no comment or "to pursue other interests" will alert investors attuned to the usual etiquette. Perhaps nothing more of a director is required or should be expected. The silent resignation of a noncelebrity director may provide a muted alert to investors. The concurrent or nearly concurrent resignation in silence of two or more directors may send a siren alert to investors.

But, an unvarnished statement by a departing director could be a final service to the corporation and to investors. The more detailed and candid the departing comments are, the greater the service to investors and the greater possibility that the director will be ostracized for breach of the complicity that passes for board etiquette.

Any statement would need to balance disclosure and confidentiality. A director might issue a pithy statement such as "I am resigning because a conflict of interest has emerged," which would not, for example, specify that the company is considering a hostile takeover, the consideration of which constitutes the conflict of interest. Or, a director might say, "I disagree with and cannot support certain [unspecified] issues/directions/decisions/actions." Definitely, before issuing a statement, a prudent director would consult with a legal adviser independent of the company and the board, probably with a mentor or close friend, and, out of courtesy, with the board chair.

How to push
Pushing out a director is like firing an employee — it’s distasteful, done reluctantly and often done badly. The worst employee firing that I saw was years ago. A decision was made in anger mid-Friday afternoon, the person was called into the boss’s office about 4:30, told he was fired and that he would get the reference he deserved. Then he was sent home to start his two-week holiday. Hopefully, no employee would be brutalized that way today.

Directors do not have the protection of a labour board, but the standards of courtesy and dignity apply to firing directors, too. Directors should be terminated the same way a modern, enlightened employer would terminate an employee — for the right reasons, through a fair process and with dignity. The right reasons are a wise determination of what is best for the organization. A fair process is care, objectivity and progressive discipline. There should be careful evaluation of all directors’ contributions and coaching and mentoring to help improve performance. Dignity means the director is handled with privacy, discretion and kind firmness, and the company tries to provide a graceful exit.

Conflicts of interest, acrimonious board relations and proxy fights mean some director terminations are nasty, but they should be as rare as nasty employee firings should be — in other words, very rare.

Occasionally someone tries to force an employee to quit by making life unpleasant. Doing that to an employee or a director is mean-spirited and gutless.

Who should deliver the bad news? The chair should. Or, if the chair is to be fired, a senior director should deliver the news.

Be willing to serve
Before leaving a board, though, consider the reasons to serve on boards. Board service is an opportunity to add résumé value, to learn from seasoned fellow board members, to network, to contribute in a high-level, strategic sense and to contribute to companies and not-for-profit organizations.

The not-for-profit sector is prime for CAs. Young CAs can hone their strategic and interpersonal skills while making valuable business and community contacts. Most importantly, we should give something to our community and our world. Service on the boards of hospitals, universities, churches, charitable organizations and political parties is a way to make our communities and our world better — one decision at a time. CAs can help make better decisions.

Peter McCann, Dipl.A.A., MBA, ICD.D, MCCA, McCann Corporate Consulting Associates