The Constituency Director

This post is from Joseph Hinsey of Harvard Business School.

“Constituency director” is a somewhat unfamiliar term in the corporate lexicon for public companies. Perhaps even less familiar, in terms of corporate law and corporate governance, is the status of a “constituency director” vis-à-vis the duty of loyalty and traditional fiduciary duty; specifically, is it different than time-honored expectations imposed upon a typical director serving on the board of a public company?

What is a “constituency director”? We deal here with public company directors whose board membership is attributable to one or more particular constituencies, such as a director whose board election is (or would seem to be) otherwise traceable to a recognizable voting constituency or “sponsor”. [nota bene: this commentary is focused upon – and limited to – the public company environment, for private company situations will often present understandably different considerations (e.g., the family corporation).] Classic examples would include parent company executives serving on the board of a majority-owned subsidiary that is still a public company and union representatives serving on the board pursuant to a collective bargaining agreement. Other examples would typically be (i) private equity or venture capital representatives continuing on the board of the enterprise, after it has again become a public company, until their firm’s investment has been completely liquidated, (ii) directors elected by a separate class of securities (such as a preferred) entitled to board representation so long as that class of securities is outstanding, and (iii) family board members (with significant equity ownership – directly or in family hands) continuing their directorships after their privately-held family enterprise becomes a public company.

Not much has been written about constituency directors over the years. There has been some interesting commentary in a couple of rather-dated legal periodicals – dealing with “representative directors”:

Andrew Bogen, “Directors Duties to Which Stockholders?”, Corporate Governance Advisor, Dec. 1992/Jan. 1993, p. 24.

The author addresses the dilemma of the “representative director” designated to serve on the board of a publicly-traded corporation. Noting several nuanced situations posing possible complications for the controlled director that go beyond the controlling stockholder’s self-dealing transactions as well as the fact that (as of the time the matter was addressed) “the cases do not reveal strict scrutiny of any but the most clearly drawn conflicts“, he concludes that what may be required is (i) “a high degree of candor by the representative director [re his “parochial interest perspective” in behalf of the controlling stockholder] and (ii) an informed vote of just disinterested directors “in situations in which the potential for [representative directors’] conflict is acute.”

Cyril Moscow, “The Representative Director Problem”, 16
Insights 12 (June 2002).

The author addresses what he terms “the rubric” vs “the reality”; that is: “[w]hile directors representing controlling shareholders, venture capitalists and preferred shareholders are elected to protect the interests of their sponsors … accepted doctrine says that they owe undivided loyalty to their corporation and all shareholders.”

The author continues: “[i]n both closely held and publicly traded corporations, common experience shows that the parties expect that a representative director will express the views of the party that the director represents. There is little purpose in cumulative voting and class election of directors if the directors who are chosen do not advocate the views of the shareholders electing them. Similarly, directors designated through contractual rights by creditors or venture capitalists are expected to favor the interests of those designating them. The problem arises under the corporate norm when expected advocacy by a representative director evolves into actions of the director, whether in considering transactions with the sponsor, a veto of a corporate action, information sharing, or other actions that may benefit the sponsor.” In suggesting several steps that “can narrow the gap between theory and practice”, the author proposes that: “… representative directors should make full disclosure of their status and the interest of the sponsor. They should recuse themselves from transactions directly involving their sponsors and resign when a continuing conflict is unavoidable. In a controlled corporation situation, the actions of the representative director should be treated in the same manner as the action of the controlling shareholders, including a general fiduciary duty to act fairly toward the minority. In effect, the presence of representative directors in a parent-subsidiary merger can be disregarded as a court considers the actions of the parent and the protections afforded minority shareholders.”

Moscow summarizes his suggested approach as follows: “A representative director acts in a dual capacity with duties to both the corporation and the sponsor, is expected to act as an intermediary, is a representative of the sponsor, and may act freely on behalf of the sponsor unless the action directly injures the corporation or is clearly unfair to minority shareholders.”

An interesting example of the “constituency director” is perhaps the board member (to whom Moscow makes passing reference) voted into office by a major shareholder or group of shareholders (with a linked voting interest) employing cumulative voting (“CV”) to elect that board member. Such director (having a recognized “sponsor” – a “CVD”) may present a somewhat different proposition, in that cumulative voting is provided for in the corporate statutes – and, in some states (e.g., Illinois), by the constitution. It is an “opt out” provision in some corporate statutes and in others, including Delaware (and the Model Act), the provision involves “opt in”.

The origins of cumulative voting are rather murky. Cumulative voting for corporate directors – and for representatives elected to serve in the Illinois General Assembly – was incorporated in the Illinois State Constitution that was adopted in 1870. The Opinion of the Illinois Supreme Court in Wolfson v. Avery, 6 Ill 2d. 78, 126 N.E. 2d 701 (1955), provides some history. The WOLFSON case involved construction of the cumulative voting provision in the State’s Constitution (and the validity of a statute permitting classified boards – which the Court held to be unconstitutional) but it provides no insight as to CVDs’ fiduciary duties. [The concurrent introduction of cumulative voting for the election of General Assembly Representatives (“CVRs”) arguably manifested intended “voter representation” (i.e., “sponsor bias”) when CVRs participate in General Assembly activities!]

The Opinion does, however, provide a detailed background for the genesis of cumulative voting – at least in Illinois – which the Court characterized as “a method designed to enable minority stockholders to gain representation on the board of directors“. The Opinion referred to several press commentaries (published contemporaneously with the Constitutional Convention activity and viewed by the Court to be akin to “Federalist Papers” for purposes of the Illinois Constitution’s interpretation) which indicated that the CV concept was intended to permit minority shareholders the ability to “represent” their interests in the boardroom. The apparent intention, according to the press accounts, was “proportional representation” that would enable the minority shareholders “to protecttheir interests and arguably “to protect” against a rapacious majority (e.g., the Gould-Fisk crowd); relevant thereto, the Opinion made reference to the Erie Railway’s “conspicuous and infamous example“.

While no mention was made in the opinion of “parochial” concepts, the “representation” and “protection” themes embedded in CV’s history/purpose, as outlined in WOLFSON, do appear to smack of self-interest. Based upon the WOLFSON decision, a respectable argument could perhaps be made that CVDs (i) can, (ii) are entitled to, (iii) and may even be expected to, represent the “parochial” interests of their sponsors — at least where an IL corporation is involved. QUERY: isn’t it the grand political tradition (and the normal expectation) that a CVR will act in the best interests of those who elected him/her to the General Assembly … OR … if known, those who elected the CVD to the corporate board?

The CVD’s role perhaps poses an interesting question vis-à-vis whether the statutory/constitutional backdrop suggests any measure of permitted bias re sponsor ties or accountability. However, we can pass by that conundrum for, in all likelihood, there are not many CV provisions to be found in the public company realm. To the extent that CVDs are to be found, most observers would consider them mere CDs vis-à-vis their boardroom role and status … FOR … given today’s conventional wisdom that directors’ fiduciary duties, at least in the case of public corporations, now entail service in behalf of the best interests of the corporation and all of its shareholders, dated concepts of “representation” and “protection” for minority shareholders would arguably no longer have relevance. What is to be found today is a proliferation of CDs scattered throughout public company boards.

Are they different? YES, for they are encumbered with probable sponsor expectations. Are they therefore entitled to act in a responsive way that neutralizes a corporate director’s traditional obligations to all shareholders and to the corporation? As a generalization, today’s conventional wisdom would argue NO!

One possible exception is the board representation to which a preferred class is entitled (pursuant to the charter document creating the class) in the event that class’s preferred dividends have been passed; in most cases, the class’s directorship entitlement expires when the arrearages problem has been resolved. (This is different from the board representation to which a separate class – conceivably a preferred class – is entitled as long as that class is outstanding.) One would expect there to be little question respecting the focused interests for which such a director is acting when dealing with boardroom activities – those interests’ goal will, in most cases, be centered upon clearing up the dividend arrearage problem. If so, then such “passed-preferred-dividend constituency directors” are different in that they are (presumably) expected, when engaged in boardroom deliberations and/or voting on a pending proposal, to act in the best interests of their constituency (i.e., the preferred class) and not necessarily in the best interests of the corporation and all of the public company’s shareholders.

While perhaps not an exception, an adjustment re CD’s duties and fealty – arguably not totally unreasonable — might be considered; that is, shouldn’t CDs be entitled to advocate their sponsors’ parochial interests during boardroom deliberations? If acceptable, any such concession must obviously be qualified by the requirement that there be made full disclosure vis-à-vis the CD’s bias. However, that concession should not extend to voting. If a sponsor’s parochial interests translate into transactional conflict, then the CD should invoke the common law procedures for director conflict (i.e., disclosure/recusal) or a corporate statute’s provisions re directors’ conflicting interest transactions (see Model Act section 8.60 et seq.). If not, then the situation becomes a matter for the boardroom’s anecdotal evaluation. Relevant thereto, the “shareholder value” justification will often call for caution. For example, the paring of R&D will typically enhance current earnings – translating into market price appreciation that will benefit all shareholders (and, by the same token, implement a sponsor’s “hidden agenda” re an exit strategy for the liquidation of the LBO investment) BUT reducing R&D may not be in the corporation’s best interest.

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One Comment

  1. Caroline V Rider
    Posted Friday, January 25, 2008 at 2:51 pm | Permalink

    The last paragraph of your post interests me particularly. When an action would be in the immediate financial interest of the current shareholders (paring of R&D to enhance current earnings) but may NOT be in the CORPORATION’s best interest….its viability and opportunities for enhanced profitability in the future… the directors’ primary fiduciary responsibility to the corporation, or to the (current) shareholders? Is case law silent on this, or unanimous, or mixed……?