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Co-op directors held to high standards. (Management Tip).

Editor's note: In the last issue we examined the circle of seven responsibilities that all directors have. This second article in a series of three discusses standards of conduct applied to directors and the sources of legal liability imposed on directors when they don't meet the standards. It concludes with a discussion of protections for individual directors against personal liability. Just as responsibilities can be divided into seven distinct, yet related, items, standards of conduct, liabilities and responses can be viewed in seven steps.

1. Directors' roles in perspective

A number of responsibilities are imposed on a cooperative board of directors, but where do individual directors fit in? Four perspectives of directors' roles help identify board and individual director responsibilities. Starting with the broadest perspective and narrowing the view to the individual director gives the following breakdown.

The cooperative is a business organization, almost always a corporation. All of the substantial rules governing cooperative directors come from corporate law.

The cooperative is a very special kind of corporation. Cooperatives operate according to appropriate cooperative rules or principles. These unique cooperative attributes define cooperatives' unique objectives, they require specialized income distribution and financing techniques, they impose unusual decisions on the board of directors and they give cooperative directors "something else to think about."

Narrowing the perspective further, the board of directors acts as a body. The power to act on behalf of the cooperative is given to the board of directors as a body, not to individual directors. No special power is given to an individual board member to act officially. As an individual, a board member has no greater authority than an ordinary cooperative member. The board derives its authority from the incorporation statutes, articles of incorporation, bylaws, and the members. These all identify the board of directors as the governing body.

This perspective further defines an individual director's participation in the cooperative. Decisions are board of director decisions, so an individual director must be able to work effectively within the dynamics of the board to influence board decisions. The board as a whole will be effective only if procedures, committee structures and interaction is conducive to good decision-making. If a director objects to a decision, it is imperative that a negative vote be recorded, otherwise the director will be held to have agreed with the decision.

Responsibilities, standards of conduct and possible liabilities fall on board members as individuals. If the standards of conduct are not met, individual directors may be liable to shareholders and members, to the cooperative, to creditors, to patrons and to the public through civil or criminal laws. What are the standards of conduct by which directors are measured?

2. Standards of conduct

Standards of conduct for corporate directors have been developed over many years by judicial decisions and legislative action. Although cooperative directors face numerous special problems, no separate set of standards has ever been developed for cooperative directors. Therefore, corporate rules generally apply to cooperative directors.

Standards applicable to cooperative directors (as is the case with corporate directors) are usually divided into three "duties." These are summaries of many decisions and statutes and are stated in general terms in this article. The three duties are "duty of obedience," "duty of care" and "duty of loyalty."

3. Duty of obedience

The term "duty of obedience" sounds odd but is logical when explained. The duty means first that directors must perform their roles in conformity with the statutes and terms of the cooperative's documented requirements for the directors. The authority given to the board of directors is defined, as is the purpose of the cooperative. Acts beyond those limits are "ultra vires" and are not authorized.

Neither may the board make decisions that are either themselves illegal or that will cause the cooperative to do something illegal. The duty of obedience also implies that the board should mandate necessary records and record-keeping, internal procedures, policies and compliance programs, then supervise the process to the extent necessary to protect the cooperative from illegal or improper actions.

4. Duty of care

The duty of care, also called the duty of diligence, has developed in judicial decisions but is also found in many corporate statutes. Statutes typically describe the duty of care in three parts: good faith, prudence and judgment.

Directors are required to act in good faith in all circumstances. Directors must also exercise care that an ordinary person in a like position would in similar situations. Finally, a director must make decisions for the cooperative in a manner that he or she reasonably believes to be in the best interests of the cooperative. Directors have the highest obligation to the cooperative and stand in a relationship of trust--a fiduciary relationship. Good faith, conscientious care and best judgments are expected of each and every director.

Diligence and care raise two particular challenges for cooperative directors. Directors may fail in their duty if the board does not adequately supervise management. The board must devise some way to be sure that management and employees conduct themselves in the cooperative's affairs in an ethical and legal manner. The board also establishes the cooperative's strategic direction and evaluates management's progress toward the cooperative's goals. In addition to selecting top management (usually the manager or CEO), the board's duty of diligence requires that the board evaluate management's performance, establish succession plans and, if necessary, dismiss top management.

Often, questions about a director's performance revolve around what the director knows. Generally, ignorance does not excuse a director from liability. Directors must know what they are doing or they cannot satisfy their duty of care. The knowledge requirement is usually divided into two important parts. Directors will be held accountable for what they know and what they should know. A director who is actually ignorant of a fact is not excused if the law requires that the fact should have been known by the director.

How is a director to gain this knowledge? Directors are sometimes said to have a duty to inquire about facts which are required for them to carry out all of their responsibilities. Directors have a right to inspect all books and records. They have the additional duty to understand the financial condition of the cooperative and its business operations. Directors are presumed to know what is in the cooperative's books and records. As a general statement, directors will be charged with knowledge of what it is their duty to know.

5. Duty of loyalty

Loyalty is perhaps the most troublesome area of liability in corporate law, including cooperative law. It is troublesome because it is not well understood, and the presence of disloyalty or conflicts of interest is devastating to a director's personal position of trust in the cooperative. As has been mentioned, directors occupy a position of highest trust and confidence upon which the cooperative and the entire membership relies. That position must be protected in any action taken and in any decisions made.

Several kinds of behavior are prohibited by the duty of loyalty. Self-dealing, where the director makes a special profit by doing business with the cooperative, is a breach of the duty of loyalty. As discussed in the previous article, directors of cooperatives are placed almost automatically in a position of dealing with the cooperative. This is not a problem if handled properly. In fact, a common statutory provision describes permissible situations. A typical provision states "No director, during the term of his office, shall be a party to a contract for profit with the association differing in any way from the business relations accorded a regular member or holders of common stock of the association or others, or differing from terms generally current in that district." Conflicts of interest situations always pose special challenges.

The duty of loyalty imposes other restrictions on directors. A director will violate the duty of loyalty by dealing with someone directly who could have otherwise dealt with the cooperative. This is called "appropriating the cooperative's opportunity." Loyalty also requires the highest degree of honesty and fair dealing with the cooperative and on the cooperative's behalf.

Directors are often in a position where they could violate the final aspect of the duty of loyalty: that of confidentiality. Directors are privy to information about the cooperative that may not be public. This is particularly the case where directors have access to information about the affairs of other members of the cooperative. Directors are under strict prohibitions about either divulging confidential information to anyone else or using it for their own benefit regardless of the harm to the cooperative.

Generally, a violation of the duty of loyalty, typically in situations referred to as conflicts of interest, is the quickest and surest way to make a director liable for wrongdoing.

6. The business judgment rule

Directors constantly exercise judgment on behalf of the cooperative, and sometimes that judgment does not lead to the best outcomes for the cooperative. Unexpected events can turn a good plan bad. Or directors may simply make a mistake in judgment. What happens when directors' actions lead to losses or other detriment to the cooperative?

Normally, courts will not interfere with the internal operations of a business to replace the judgments of the directors with the court's own judgment on business matters after the fact. The business judgment rule says that, absent fraud or self-dealing, business judgments made by directors will not be overturned by the courts and will not lead to director liability. Directors do not and cannot guarantee the success of the cooperative or each decision made.

Courts have generally given three reasons for the business judgment rule. Few members would be willing to serve as cooperative directors if they faced personal liability for good faith errors in judgments that results in harm to the cooperative. Courts also recognize that courts themselves are ill-equipped to make business judgments for directors and that second-guessing board decisions is not an efficient way to monitor directors. Finally, a cooperative cannot be managed efficiently if directors are not given wide latitude in law to handle the cooperative's affairs.

It is important to understand the limits of the business judgment rule. Courts usually say that the authority of directors is absolute when they act within the law, and questions of policy and internal management are--in the absence of nonfeasance, misfeasance or malfeasance--left wholly to their discretion. The rule is not a protection if the offending action was an abuse of the board's discretion, was tainted with board member conflicts of interest or was a result of the directors' abdication of their duties to the cooperative. Courts will step in and hold directors liable for their actions when directors are guilty of willful abuse of their discretionary powers, or bad faith, or of neglected duty, or of perversion of the purposes of the corporation, or when fraud or breach of trust is involved. Otherwise, directors are not personally liable for mistakes while exercising their informed, best judgment.

7. Minimizing risk

An easy but inadequate suggestion for avoiding problems as a cooperative director is to understand and appreciate the responsibilities listed in the first article in this series, know and adhere to all standards of conduct in this article and make no mistakes that may be detrimental to the cooperative. The first two suggestions are in the control of each director and are, in fact, the best defenses to legal challenges to director performance.

Protection is best when a proactive attitude is adopted by each director to know the responsibilities and standards, understand what it means for the director's performance and identify particularly sensitive issues in the cooperative, for the board of directors and regarding the director's own personal performance.

Directors may also give attention to several other actions and practices that are beneficial to their performance. Board structure, proper use of committees, effective board discussions and leadership, flows of information from management to the board and good board-management relations can avoid a number of problems. Directors may rely on experts, advisors, employees, and board committees, within certain limits. Reliance does not relieve directors of their responsibilities but does show care and diligence.

Reliance on others must, of course, be justified and cannot amount to abdication of responsibilities and duties. Director training is key to effective directorship. Effective training programs must go far beyond indoctrination by management about the cooperative's business from management's viewpoint.

Compliance programs can be helpful, and in some cases are necessary, to implement directors duties of care and management monitoring. Compliance programs are formalized internal programs to monitor certain types of behavior to be sure neither the cooperative nor employees violate some law or fail to take a required action. These programs are typically designed around legal requirements such as environmental issues, antitrust and securities laws, financing issues, or special problems that may be sensitive for a particular cooperative. To be effective, the board must insist on workable programs, must monitor their implementation and insist on full support by management at all levels. In some cases, a poor compliance program is more likely to cause problems than no program at all.

Legal audits are another technique directors may use to assist them in their duties. A legal audit can include review of the cooperative's legal structure and documents that govern the cooperative internally as well as its relationships with members and others, analysis of assets and liabilities, evaluation of potential claims against the cooperative, a thorough examination of procedures in place and recommendations for changes needed to address weaknesses.

Whatever action is taken, the overall attitude of directors should be active, positive, creative and dynamic. The great responsibilities imposed on cooperative directors and the associated potential for liability should not lead to a defensive posture.

Indemnification

Legal challenges to cooperative directors and litigation involving directors cannot always be avoided. The trauma of such actions against directors is significant. In one regard, the burdens can be relieved somewhat in most circumstances.

Legislation has been used in many states to allow a corporation (and presumably a cooperative) to indemnify directors who are subject to legal action that requires expenditures of sometimes substantial sums in defense. Indemnification in this context simply means that the cooperative pays for costs incurred by a director who is responding to legal actions for some act as a director.

In addition to authorizing indemnification and describing procedures for indemnification, statutes usually establish standards of conduct permitting indemnification. A cooperative may not be permitted to indemnify a director where the director's conduct in question fails to meet certain standards of conduct. For example, directors who cause harm to the cooperative by self-dealing or fraud against the cooperative cannot demand indemnification when they are sued for such actions. When contemplating indemnification, a board considers not only the applicable statutory requirements and restrictions, but also determines under what circumstances the cooperative should or should not indemnify a director.

Insurance

Cooperatives can purchase insurance to protect the cooperative and its directors in case costs are incurred defending litigation against directors. Usually called D & O insurance because it covers both directors and officers, the insurance is often in the form of two policies. One covers directors to the extent the cooperative does not fully indemnify them for their costs. The other covers the cooperative itself for the indemnification made to directors.

As with nearly any insurance arrangement, each policy will be tailored to the needs of the cooperative. Terms will be negotiated that include: level of coverage, exclusions, claims or occurrences methods, deductibles and general claims procedures.

The Circle of Seven Responsibilities

(As described in the previous article in this series, see July-August 2002 issue, page 30.)

Directors:

1. Represent members

2. Establish cooperative policies

3. Hire and supervise management

4. Oversee acquisition and preservation of cooperative assets

5. Preserve the cooperative character of the organization

6. Assess the cooperative's performance

7. Inform members

Do corporate statutes apply to cooperative directors?

Generally yes, for two reasons. Cooperative incorporation statutes usually state that corporate law applies to cooperatives unless corporate law conflicts. Cooperatives are incorporated bodies that have all of the basic characteristics of corporations; directors' roles, duties and responsibilities are no exception.

Conflicts of interest

Conflicts of interest involving directors are unavoidable and can have serious consequences if not handled properly by the board and the cooperative. This topic will be further examined in the third part of this series.

Implementing exercise

Establish a schedule to considers--at board meetings or ancillary meetings--each of the standards of conduct imposed on directors. Systematically consider each standard and its requirements. At each meeting, thoroughly examine one of the standards outlined in this article.

* What specifically does the board currently do to meet the standard?

* What are board's weaknesses regarding the standard?

* Does each director have the skill, interest and time to consider and respond to the standard's requirements?

* Does file board have the knowledge and information necessary to meet the standards?

* What specific steps can be taken to make the board meet every standard?

* Is there consensus on the board's performance?

* Would members agree with the board's self-assessment?

Even more than the board's responsibilities, the standards are personal to each director. Each director should individually address the issue and propose his or her own solution to problems perceived about the standard of conduct under discussion. These sessions may be more effective if management is not present.

The board should also consider the mechanisms the cooperative has in place to protect directors, such as indemnification provisions and D & O insurance. Assessment of state law applicable to the cooperative and directors will be part of the analysis.
James Baarda
USDA RBS Economist
james.baarda@usda.gov
COPYRIGHT 2002 U.S. Department of Agriculture, Rural Business - Cooperative Service
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2002 Gale, Cengage Learning. All rights reserved.

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Author:Baarda, James
Publication:Rural Cooperatives
Date:Sep 1, 2002
Words:2938
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