Why not put a firm on your board?

by on July 31, 2014 at 2:32 am in Economics, Law, Uncategorized | Permalink

State corporate law requires that “natural persons” provide director services. This Article puts this obligation to scrutiny, and concludes that there are significant gains that could be realized by permitting firms (be they partnerships, corporations, or other business entities) to provide board services. We call these firms “board service providers” (BSPs). We argue that hiring a BSP to provide board services instead of a loose group of sole proprietorships will increase board accountability, both from markets and from courts. The potential economies of scale and scope in the board services industry (including vertical integration of consultants and other board member support functions), as well as the benefits of risk pooling and talent allocation, mean that large professional director services firms may arise, and thereby create a market for corporate governance distinct from the market for corporate control. More transparency about board performance, including better pricing of governance by the market, as well as increased reputational assets at stake in board decisions, means improved corporate governance, all else being equal. But our goal in this Article is not necessarily to increase shareholder control over firms; we show how a firm providing board services could be used to increase managerial power as well. This shows the neutrality of our proposed reform, which can therefore be thought of as a reconceptualization of what a board is rather than a claim about the optimal locus of corporate power.

That is from a Stanford Law Review piece by Stephen M. Bainbridge and M. Todd Henderson.  For the pointer I thank Kevin Lewis.

Kevin Erdmann July 31, 2014 at 3:05 am

I think it would be a good idea to let corporations run for office. Basically we have 2 corporations with a monopoly on public office now. How about voting for Amazon or chipotle? They would need to follow the same ethical guidelines that the human office holders follow. I think that could produce a vibrant political system.

Kevin Erdmann July 31, 2014 at 3:06 am

Sorry. A duopoly.

andrew' July 31, 2014 at 6:31 am

You were right the first time.

Larry July 31, 2014 at 3:23 pm

A legislative service provider. Great idea.

Li Zhi July 31, 2014 at 9:47 am

…and when (obviously, not “if”) they break the law?

Kevin Erdmann July 31, 2014 at 8:38 pm

One of the advantages would be that corporations would be much less likely to be divisive or underhanded. Compare any commercial advertisement to political advertisements or corporate shareholder meetings to political conventions. The level of civility and honesty is not even in the same universe.

Area Man August 1, 2014 at 11:45 am

That sounds like something a Chipotlecrat would say..

Maximum Liberty July 31, 2014 at 6:45 pm

“A chicken for every burrito.”
Chipotle for President 2016

Hero Protagonist July 31, 2014 at 9:50 pm

Scaled Auto-Communicratic Capitalism. SACC™

Asher July 31, 2014 at 3:38 am

I’ve studied and taught corporate governance, and I think this is a great idea. At the end of the day, being a director is a profession. Your job is to skillfully represent the interests of the owners, who are both uninformed (about the firm, the industry and about corporate governance itself) and dispersed. Most of the people who engage in this profession never studied it, many don’t have a high level of professionalism, and most can’t devote enough time to really do a good job. Having individual “expert directors” is another interesting direction, but having large firms would create a large pool of expertise and much more transparency and accountability.

Legal persons running for office is not a good idea because the scope of discretion is so much larger. Some politicians are more professional than others but it is not really a profession. An alternative take on this is that to some extent parties fulfill this role, so perhaps people do vote for legal persons.

Jon Rodney July 31, 2014 at 8:27 am

I wonder how this would work as a practical matter. If certain “board service providers” started to take on a dominant market position, wouldn’t they end up serving on multiple boards in the same industry? How would we deal with the resulting conflicts of interest?

samson July 31, 2014 at 10:26 am

exactly. this is another idea for the utopic world of competitive markets and a strong antitrust regulator.

Hero Protagonist July 31, 2014 at 10:02 pm

Seriously? So… human beings, conflict, and idiosyncratic decision making… social networks, relationships, reputation… ability to make decisions that fly in the face of the facts, ethics…. I see something like this and understand that the people proposing it really have never really been on a board, and, never will be. You don’t just show up at a meeting and decide things. You don’t there though hard work and voting. There is an entire culture around these things. Services are much more hackable by unseen forces, more likely to be trapped in governance and rules based morale delima’s, and ultimately unable to make a decision. take the word services, group, etc out of this and put the words “bots, automation” etc.

It kind of makes me want to go write a cyberpunk book – it is so not a good thing that it will likely happen.

Jeroen Delvoie July 31, 2014 at 3:50 am

This is legal in many European countries, but has not led to the emergence of board services firms as envisaged by the authors (does this count as failing the market test?).

In the typical situation, instead of appointing a chosen board member as a natural person, his/her (unipersonal) management company is appointed for tax and/or liability reasons. The technique is also sometimes used in other settings, such as for organizing control in family-owned firms.

There has been some pushback in recent years in some countries, e.g. a statutory rule which requires the company-director to appoint a natural person as its “permanent representative”, who will then be personally liable as a director.

dearieme July 31, 2014 at 4:50 am

“This is legal in many European countries”: memory – ever untrustworthy – says that I’ve read of a case of this in Britain. If so, it’s apparently legit under Common Law, not just under Roman Law.

Florian July 31, 2014 at 6:16 am

This is the legal setup of the German “GmbH&Co.KG”.

The “KG” is the real operating company.
It requires at least 2 owners:
one “Komanditist” (the “&Co.” part of this setup) who has shares in the KG but no managment influence.
and one “Komplementaer” who has shares, manages the company and has full personal liability.

The “Komplementaer” is not required to be a natural person. Frequently, this (management!) position is filled by another (ltd.) firm, the “GmbH” (which generally only has a tiny token share in the KG and whose sole purpose is to manage and control the KG and to shelter the “real” Kommanditist-owners from personal liability).

(I realize, that this is probably not exactly what the authors had in mind when they wrote about “putting a firm on your board”. But it shows that there already exists a legal framework for this idea).

prior_approval July 31, 2014 at 6:55 am

Just not a way to profit from it.

And here is an English language link explaining various German business forms – http://www.stuttgart.ihk24.de/english/fairplay/Company_Law/959412/Legal_forms_of_Doing_Business_in_Germany.html

Brett Dunbar July 31, 2014 at 8:28 pm

Current legal position:

Corporate Directors

From 1st October 2010 all companies are required to have at least one director who is a natural person. (section 155 of the 2006 Companies Act)

Companies have not been allowed to incorporate with only corporate officers since 1 October 2008. Some companies incorporated before the 2006 Companies Act received royal assent were given a transitional period to comply.

This transitional period ended on 1 October 2010.

We have already written to many companies to advise them of this new requirement.

We intend to review the position at the end of October and decide on the best course of action for those companies who appear to still be in breach of section 155.

Under section 156 we can issue a direction requiring companies to appoint natural directors. If a company fails to comply with the direction the company and every officer of the company who is in default (this includes shadow directors) commits an offence.

A person guilty of an offence under this section is liable to a fine of up to £5000 on conviction.

Although Companies House will respond to complaints, we also intend to pro-actively seek compliance with section 155. Securing compliance with the Act is our primary objective and in appropriate cases we will consider taking prosecution action if the company persistently fails to comply.

Following a recent consultation the government plans to prohibit corporate directors in almost all circumstances. In practice what they mainly did was allow criminals to conceal their position as beneficial owners of companies while having rather few benefits.

3. Opaque corporate control through corporate directors
This section covers the way forward in relation to the content of questions 35 to 38 in the Transparency and Trust discussion paper.

Directors influence and are responsible for actions taken in a company’s name, whether normal functions, steps precipitated by financial difficulties or using the company as a vehicle for illicit activities. In the current UK framework, there is potential for a lack of transparency and accountability of directors. This can arise when the director registered at Companies House is a front obscuring those who really exercise control, which we cover in the next section. It can also occur through the use of corporate directors – where a company director is not a natural person (an individual) but a legal person (another company).

Corporate directors can bring about a lack of transparency and accountability with respect to the individuals influencing the company. A person’s details and relationship to the company can be challenging to identify, which, among other consequences, can hinder law enforcement investigations. Even when they are identifiable, there may be no legal route to holding these individuals to account (See for example HMRC v Holland (2010) UKSC51). More broadly, a company acting as a director, instead of an accountable individual, could suggest the potential for a deficit in corporate governance and oversight.

Under the Companies Act 2006, companies are permitted to appoint corporate directors on the basis that at least one of their directors is an individual. Limited Liability Partnerships (LLPs) are not companies but are subject to many of the provisions in the Companies Act 2006; they can appoint corporate ‘members’ without restriction. Across the UK, 67,000 (2 per cent of) companies and LLPs have a corporate director or member. In some other countries, such as Germany and Australia, only individuals can be company directors.

In the discussion paper, we sought views on the proposal that company directors should be individuals. We wanted to consider if UK companies should be prohibited from appointing corporate directors, on the basis this would increase the transparency and accountability of those who really control UK companies.

Views Received

Support for change to the law, which currently allows a company director to be a legal person (another company), was clear. Nearly half the responses were supportive of a complete prohibition of the use of corporate directors in the UK. This support came from NGOs in favour of a range of robust measures to improve corporate transparency. Law enforcement agencies were also supportive, since the opacity afforded by corporate directors can hinder their investigations. Support also came from business representative organisations – the IoD considered a director’s role to be an accountable ‘human face’ of a company. Some individual professional services businesses, including Grant Thornton, submitted that on balance action was warranted because there was always an individual decision-maker behind a corporate director.

Several respondents felt there were situations where the use of corporate directors was valuable. They consequently had concerns about a complete prohibition. These respondents demonstrated the importance of preserving efficient business practice where corporate directors might be used for particular purposes, and where there might be a lower risk of financial crime and high standards of corporate governance or regulatory oversight. Such situations were reported to include: group structures involving large (and listed) companies, pension funds, charities, and Open-Ended Investment Companies (OEICs). Such responses came from some business representative organisations and from some large multinational groups.

If we were to account for these concerns in some way, for instance through exemptions to a wider prohibition, then around three quarters of respondents were supportive of steps to limit the use of corporate directors.

Very few reasons were presented for not limiting the use of corporate directors, beyond those points relating to specific circumstances as described. A small number of respondents offered alternative approaches (including licensing corporate directors).

We also asked about suitable timeframes for transition to a new regime. Responses ranged from 6 months to 5 years. Overall, one year was the most widely quoted figure.
Government Response

On balance, we want to ensure – and send a signal – that for the majority of UK companies appointing a company (or legal person) as a director is not an option. Directors should normally be individuals (natural persons). This is a clear change to the UK’s approach to corporate transparency and corporate governance.
.
At the same time we believe we need a pragmatic approach. Corporate directors are considered useful in some parts of the UK economy, particularly areas where, given wider disclosure requirements and regulatory regimes, concerns about corporate transparency and corporate governance are less acute than elsewhere. Throughout these reforms, and in the complementary reforms to Companies House Filing Requirements, we are seeking to implement improvements to the business environment without increasing unnecessary burdens.
.
We have therefore decided to pursue a default prohibition of corporate directors, whilst additionally providing for limited exemptions to that prohibition. Most companies will not be able to appoint a corporate director. But a company will be able to continue to use or to appoint a new corporate director if it is within scope of the exemptions. We can see a case for consistency and the inclusion of LLPs in this system, alongside companies, and welcome views on this point.

The basis for the exemptions will relate to situations where the use of corporate directors provides particular business benefits, where that coincides with areas of low risk of financial crime, high standards of corporate governance or high levels of disclosure or regulatory oversight. Based on responses to the discussion paper, we are currently considering exemptions applying to:

Group structures including large listed companies
Group structures including large private companies
Charities

We also intend that the use of corporate directors by OEICs (where they are licensed by the FCA), and the use of corporate trustees, should continue. We would be happy to consider scope further as we develop this package for full implementation.

The new position will apply to new director appointments, and to existing corporate directors. To reduce abuse of the UK company structure, it is important we take steps to remove existing corporate directors (outside the scope of the exemptions) from the system.
.
We will introduce a robust system of compliance to ensure the use of corporate directors is indeed limited. This will include updated requirements to notify Companies House and enforcement thereof, including criminal offences where necessary.

To implement these changes, we will bring forward primary legislation as soon as Parliamentary time allows. This will update the current specification that only one director of a company need be an individual (a natural person), and set out the default position of directors being individuals, not companies. We intend to define the exemptions under which an appointment of a corporate director could continue to be made in parallel in secondary legislation.

We propose a one year period for companies to become compliant with the new regime, which we consider should be sufficient given effective advance notice. We will provide more detail in guidance as to how compliance should be achieved, including details of enforcement.

Summary Way Forward

We intend to prohibit the use of one company as the director of another company – corporate directors – with limited and specific exemptions where the use of corporate directors is of higher value and lower risk.

dixie July 31, 2014 at 4:26 am

Why not put an algorithm on your board.
http://www.businessinsider.com.au/vital-named-to-board-2014-5
“A Venture Capital Firm Just Named An Algorithm To Its Board Of Directors”

Dan Weber July 31, 2014 at 8:14 am
Mo July 31, 2014 at 9:15 am

I don’t see why you couldn’t have a board management services firm under current law, you just have the board seat go to “a representative of BoardCorp”.

Dave July 31, 2014 at 3:41 pm

Agreed. There are legal distinctions that can be important in certain instances – particularly when considering a related party transaction or a situation to which some shareholders might object – but the proposed system is close to the de facto situation at most closely-held companies. Here are 3 situations that immediately come to mind:

- When a private equity fund owns a company, a majority of the directors are typically investment professionals from the private equity fund. Similar with VC firms that invest in start-up, though a single VC firm usually provides less than a majority of the board;

- In joint ventures between two or more companies, they usually each appoint some number of directors and select their own executives to serve as directors;

- If a company has a wholly-owned subsidiary, the parent usually appoints one or more of its own executives as directors

Enrique July 31, 2014 at 9:26 am

The idea of a “market for corporate governance” is a very Coasian one … Couldn’t we extend this idea to politics as well? See here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1568905

Bill July 31, 2014 at 9:28 am

Board Service Providers, if they overlap with competing companies, could be viewed as a coordinating or facilitating device for an illegal agreement.

Section 8 of the Clayton Act deals with competing board overlaps, and is enforced.

The Antitrust Division in the past has investigated the use of consultants serving as facilitating devices to coordinate behavior in the past. Hire the same consultant to tell you what he thinks the price or market conditions are, and what the likely response of a rival would be to a price increase, given that the consultant provides the same information and service to a competitor.

I would worry about a Board Service Provider serving the same industry and having as its Motto:

“Let The Circle Be Unbroken”

I think the other issue that is not addressed her is director independence and judgment. Can you imagine a lawsuit involving a directors decision who acted against the advice of a Board Service Provider who was more knowledgeable than the director it served, and was hired for that reason.

Litigation Now, Litigation Forever.

Bill July 31, 2014 at 9:30 am

“addressed here” rather than “addressed her”

nl7 July 31, 2014 at 10:32 am

The risk I imagine is that the entity directors would be treated as de facto insurers of the company – deep pockets that disaffected shareholders can pursue. The current situation gives significant latitude to directors for major mistakes essentially as long as they consult some experts, avoid excessively biased information, and didn’t profit from the mistake.

I think the Business Judgment Rule is maintained in part because judges and even lawyers think of directors less as active managers and more or important people who helicopter in for periodic meetings and reviews. If directors are specifically trained and professionalized, and if they are entities with deep wells of cash, then I think we can expect plaintiff lawyers to be moderately more aggressive about director liability and judges to be less sympathetic.

Asher July 31, 2014 at 11:09 am

This could be considered a feature rather than a bug. Part of the accountability of these firms could be their legal accountability.

Bill July 31, 2014 at 3:36 pm

Accountability financial accountability is limited by the advising firm getting incorporated and having incorporated subs handle each account.

Dan Lavatan July 31, 2014 at 5:12 pm

I’ve always supported having corporate directors and am glad someone finally caught onto this. I should also point out this varies quite a bit from state to state – only some states have explicit language that natural persons be directors.

M August 1, 2014 at 11:39 am

Why can’t individual directors merely use this software or firm consultants (which I’m assuming they already do)? The benefit of having an actual person as director is that someone identifiable is responsible. Naming the firm/software as the board member just lets people hide behind a mess of bureaucracy.

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